Understanding business finance; non-financial founders primer

Hey there, future Unicorn founder! If you're a founder without a financial background, understanding the basics of business finance might seem daunting, but it is super important. Did you know that around 82% of small businesses fail because of poor cash flow management knowledge? Yes, that’s what the numbers show. That means simply learning business finance and understanding cash flow management gives you a better chance than 82% of businesses currently in the market!

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In this primer, we’re going to break down the essentials of business finance in a way that's easy to understand, even if you don't have an accounting degree. Think of it as your crash course in all things money-related for your business. But remember; this is just a primer to help you get started. It is not the entire deal. 

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Ready to dive in? Let's start with basic finance terminology.

Basic Financial Terminology

Alright, let's start with the basics. Here are some key financial terms every founder should know, explained in plain English with some real-world examples.

Revenue

This is the total amount of money your business brings in from selling goods or services. For example, if you own a coffee shop and you sell 100 lattes at $5 each, your revenue for the day is $500. Simple, right? But remember, this is just the money coming in, not your profit.

Profit

This is what you get to keep after covering all your expenses. So, if your coffee shop made $500 in revenue but you spent $300 on coffee beans, cups, and wages, your profit is $200. It’s the money that stays in your pocket after everything’s paid for.

Expenses

These are the costs your business incurs to generate revenue. Think of rent for your shop, wages for your baristas, the cost of coffee beans, and even the electricity bill. All these costs need to be deducted from your revenue to figure out your profit.

Cash Flow

 This is the movement of money in and out of your business. Imagine it as the flow of cash coming into your coffee shop from latte sales and going out to pay for supplies and wages. Positive cash flow means more money is coming in than going out, which is what you want. Negative cash flow? Not so good – it means you're spending more than you're making.

Assets

 These are the things your business owns that have value. For your coffee shop, this could be your espresso machine, furniture, or even the money in your business bank account. Assets are what you use to run your business and potentially generate more revenue.

Liabilities

 These are what your business owes. If you took out a loan to buy that fancy espresso machine, the loan is a liability. Other examples include any unpaid bills or salaries you owe your employees.

Equity

 This is what’s left over after you subtract your liabilities from your assets. It represents the owner's stake in the business. If your coffee shop's assets — like equipment cash, and everything else — are worth $50,000 and you owe $20,000 in loans and bills, your equity is $30,000. This is essentially your ownership value in the business.

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Understanding these terms is crucial because they help you keep track of how well your business is doing. Plus, they’re essential when you're talking to investors, banks, or anyone else who might be interested in the financial health of your business. And trust me, getting comfortable with these basics will make everything else in business finance a lot easier to grasp! 

Understanding Financial Statements

Just how important are financial statements? Well, they are the skeleton of every business. Your business thrives or drowns on the strength of analysis you can make off your financial statements. And you won’t be making any good decisions if you cannot understand what the statements are saying. 

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I know this might sound boring already, but if you want numbers behind how your business is doing, you need to be able to understand these statements. Misunderstanding them can lead to huge losses. For example, one of the reasons for the Enron collapse in 2021 was because of opaque financial statements and many investors lost money because they didn’t read fineprints of the reports Enron released. You don’t want that to happen to your business.

Balance Sheet

Think of the balance sheet as a snapshot of what your business owns and owes at a specific point in time. It’s divided into three sections: assets, liabilities, and equity. For example, let’s go back to your coffee shop. On your balance sheet, you list all your assets and all your liabilities, like the loan for the business and unpaid bills. The difference between your assets and liabilities is your equity. So, if you have $50,000 in assets and $20,000 in liabilities, your equity is $30,000.

Income Statement

This one shows your business’s performance over some time, like a month or a year. It’s also known as the profit and loss statement (P&L). It starts with your revenue and subtracts your expenses to show your profit or loss. 

Cash Flow Statement

The cash flow statement tracks the flow of cash in and out of your business. It’s split into three parts: operating activities, investing activities, and financing activities. For example, the operating activities section might show cash coming in from latte sales and going out to pay for supplies and wages. 

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These financial statements are like your business’s report cards. They help you understand how well your business is doing, where your money is going, and what you need to work on. Plus, they’re essential when you’re looking for investors or loans, as they show outsiders the financial health of your business. Now that you know how your business looks financially, it is time for some financial forecasting. How do you plan for the future through business finance? 

Budgeting and Forecasting

Budgeting is like your financial roadmap. It helps you plan how to allocate your resources, ensuring you have enough money to cover expenses and invest in growth. It is easy to think that budgeting failures cannot be critical, but they often are. 

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Toys R Us, for example, filed for bankruptcy in 2017 after more than a decade of budgeting disasters. The company was bought through a leveraged buyout that loaded it with $5 billion in debt that required $400 million in interest payments every year. The budgeting focus should have been to get rid of that debt as quickly as possible, but that didn’t happen and the company eventually had to close down all its stores.

How to Create a Basic Budget

• List Your Income: Start by listing all your sources of revenue. For a coffee shop, this could be sales from coffee, pastries, and merchandise.
• Estimate Fixed Costs: These are regular expenses like rent, utilities, and salaries.
• Estimate Variable Costs: These change based on your sales. For a coffee shop, this includes coffee beans, milk, and cups. 
• Set Aside for Contingencies: Always allocate a portion of your budget for unexpected expenses. If your espresso machine breaks down, having a contingency fund can save the day.
• Review and Adjust: Regularly compare your budget to actual spending and adjust as needed. If you find you're spending more on milk due to increased latte sales, update your budget to reflect this.

Financial Forecasting

Financial forecasting is like looking into a crystal ball for your business. It helps predict future revenues, expenses, and cash flow, guiding your strategic decisions. 

How to Create a Financial Forecast

• Analyze Past Performance: Look at your historical data. If your coffee shop typically sees a 20% increase in sales during winter, use this information to forecast future sales.
• Consider Market Trends: Are more people opting for plant-based milk? Anticipate increased demand and adjust your forecast accordingly.
• Project Future Revenue: Based on historical data and market trends, estimate your future sales. If your coffee shop made $10,000 last December and trends suggest a 25% growth, forecast $12,500 in sales for the upcoming December.
• Estimate Future Costs: Just like with revenue, predict your future expenses. If milk prices are rising, factor this into your cost forecast.
• Review and Update: Regularly revisit your forecasts and update them based on actual performance and new data.

Financial Metrics and KPIs

Understanding financial metrics and key performance indicators (KPIs) is crucial for monitoring your business's health and making informed decisions. 

Key Metrics to Know

• Gross Margin: The percentage of revenue remaining after deducting the cost of goods sold (COGS). It's calculated as (Revenue - COGS) / Revenue.
• Net Profit Margin: The percentage of revenue left after all expenses are deducted. It's calculated as Net Profit / Revenue.
• Burn Rate: The rate at which a company is spending its cash reserves. Startups need to monitor how long they can operate before needing additional funding.

Why They Matter

These metrics help you understand profitability, efficiency, and sustainability. By regularly tracking and interpreting these KPIs, you can spot trends, identify issues, and make data-driven decisions to steer your business toward success.

Wrapping It Up

Navigating the world of business finance can seem intimidating, especially for non-financial founders, but mastering the basics is essential for success. Learning from past business failures, like Toys "R" Us, underscores the importance of sound financial management.

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Remember, financial literacy isn't just about numbers; it's about gaining the insights needed to grow and sustain your business. Keep honing your financial skills, stay curious, and seek advice when needed. With the right knowledge and tools, you'll be well-equipped to handle the financial challenges of running a successful business.