Do you know these financial terms? They’re important!
There are a few basic finance terms that every entrepreneur should fully understand. They represent the core of understanding how business development works across all stages in the life of a venture, so it’s important you understand their meaning.
Here’s a quick review of the terms you need to know:
- Earnings before Tax: An indicator of a company’s financial performance, calculated as revenue minus expenses, excluding tax. EBT is a line item on a company’s income statement that shows how much the company has earned after the cost of goods sold (COGS), interest, depreciation, general and administrative expenses and other operating expenses have been subtracted from gross sales.
- Depreciation and Amortisation: Depreciation, depletion and amortization (DD&A) are noncash expenses. Depreciation is a means of allocating the cost of a material asset over its useful life, and depletion is used to allocate the cost of extracting natural resources from the Earth and is the actual physical depletion of a natural resource by a company. Amortization is the deduction of capital expenses over a specified time period, typically the life of an asset.
- Return on investment (ROI): The only way to think about your business is with an ROI perspective. You have committed capital investment into a certain combination of assets, from which the company generates sales. Those sales cover the costs of operations and (hopefully) produce a profit. That profit, divided by the total funds invested in the company (the assets), equals the ROI to the entrepreneur. Think of it this way: Would you work all those hours and take on all that responsibility if your ROI was only 6 percent annually? The stronger the profit picture compared to the total funds employed in the enterprise, the higher the ROI.
- Internal rate of return (IRR): Every decision enacted by the entrepreneur must be viewed in terms of its internally generated return to the company. Unlike the simple division used to find the ROI, the IRR compares the net expected returns over the useful life of a project being reviewed by management to the funds spent on that decision (or project). All projects must meet a certain IRR in order to be acceptable for investment by the company. If a project cannot meet a minimum IRR, then don’t invest in it.
- Fixed asset base: This is the long-term base of the company’s operation strategy, represented by all the equipment, machinery, vehicles, facilities, IT infrastructure and long-term contracts the firm has invested in to conduct business. From a finance perspective, these assets are the revenue generators. When the entrepreneur decides to invest in a certain fixed asset configuration that becomes the base from which the company functions week in and week out, doing business and servicing its customers.
- Working capital: Current assets are those short-term funds represented by cash in the bank, funds parked in near-term instruments earning interest, funds tied up in inventory, and all those accounts receivable waiting to be collected. Subtracting the company’s current liabilities from these current assets shows how much working capital (your firm’s truest measure of liquidity) is on hand and its ability to pay for decisions in the short-term. For example, if the firm has Rs. 500,000 in current assets and Rs. 350,000 in current liabilities, then Rs. 150,000 is free and clear as working capital, available for spending on new things as needed by the company.
- Cost of capital: It refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.
- Weighted average (between debt and equity) cost of capital (WACC): This is the firm’s true annual cost to obtain and hold onto the combination of debt and equity that pays for the fixed asset base. Every time the owners contemplate investing in a new project, the IRR for that project must be at least equal to the WACC of the funds used to do that project, otherwise it makes no sense taking on that new project, because its return cannot even cover the cost of the capital employed to make the project happen.
- Risk premium: Entrepreneurs must understand that every decision they consider has an inherent level of risk associated with it. If project A is far riskier than project B, there should be a clear risk premium that could accrue to the firm if project A is enacted. But with that risk premium return, there will also be a risk premium cost to the company for the use of the funds. Business owners always have to decide whether the risk premium of additional potential return is commensurate with the additional risk costs that come with doing that investment project.
- Capital budgeting or investment appraisal: It is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
If you didn’t know this, now you know better how to look at your finances! To make finance easier for you entrepreneurs, catch next week’s #financialfriday !