This week, we continue our month-long discussion on financial literacy, including best practices to increase your financial knowledge. While there are numerous reasons business owners do not have an adequate level of financial knowledge (some people are just not good with numbers, guidance from GAAP has gotten so complicated it makes it even more difficult to understand, and business owners are just “too busy” to get into it), this knowledge is crucial to having effective conversations about your business.
Can You Stand Your Financial Ground?
If the right investor came along tomorrow, how confident are you that you are prepared with accurate historical and projected financials? Can you demonstrate thorough knowledge of your company’s financials, cash flow, burn rate, and return on investment? Are you prepared to get drilled on each number you provide and have the ability to accurately explain where it came from? If you are not prepared, it will feel like the longest half hour of your life.
So, how confident are you?
If your answer is, “Not confident,” or “Somewhat confident,” it is time to make an investment in yourself. Here are a few tips to increase your financial knowledge:
- Prioritize your financial education. We know how busy you are, but think of it as the investment it truly is.
- Develop a financial advisory team. Ask these trusted individuals questions and encourage them to do the same.
- Make the cash flow statement your new best friend. This is the lifeblood of business and you should understand everything on it at all times.
- Take some basic accounting courses. It’s never been easier to take a class online.
- Connect with a CFO firm. Not everyone has all of the required resources at their fingertips. Allow the right CFO firm to become that resource as a trusted partner.
- Get a better understanding of key financial terms. We’re including some right here to help get you started.
Terms to Help You Stand Stronger
When an investor begins to ask about gross profit, net profit, or EBITDA, often the business owner’s face says it all – like when you’ve caught a teenager in a lie. Knowing these financial terms helps you not only have a more constructive conversation with potential bankers and investors, but also to truly have a better understanding of your business. Some of the basics (there are many more) include:
Aged Accounts Receivable. This is a report that categorizes a company’s accounts receivable according to how long invoices have been outstanding. This report is used as a benchmark in measuring the financial health (or lack thereof) of a company’s customers.
Burn Rate. Burn Rate refers to how much money it takes to operate your business for a period of time (generally, a month). Knowing your burn rate helps to ensure that you have enough available cash to adequately run your business. Experts advise being able to cover your burn rate for at least six months.
Cost of Goods Sold (COGS). This refers to the total cost of all labor and materials required to provide the products or services that your customers ultimately purchase.
Debt-Service Coverage Ratio (DSCR). A ratio calculated by dividing your business’s net operating income by your debt payments. This compares cash flow to debt obligations. With the information, you can determine if you can cover debts due within one year.
EBITDA. Earnings before interest, taxes, depreciation, and amortization. To calculate EBITA, take the gross margin and subtract total operating expenses, plus depreciation and amortization. Keep in mind the difference between EBITDA and EBIT. EBITDA subtracts all expenses, whereas EBIT subtracts everything except depreciation and amortization.
Gross Profit Percentage or Gross Margin. This refers to the percentage of total revenue that remains after subtracting the direct costs of producing the product or service. For example, if your company’s revenue is $400,000 in one year and your gross margin is 25%, then your gross profit is $100,000.
Profit Margin. Profit margin is the percentage of your total revenue that you retain as profit. This metric is most often analyzed on a per unit basis. To calculate profit margin, subtract overhead expenses (along with direct costs) from your sales and then divide it by your total revenue. While it may take some time for a business to start generating profit, it is ultimately what makes it valuable … and a priority for investors. It is imperative that you are confident that your revenue you are charging for the product will cover the overall cost of the organization. When you are in growth mode, this may not be the case – which is why the Cash Burn rate (referred to earlier) is so important.
Working Capital. Working capital is cash plus other current assets, less current liabilities.
Whether it’s understanding these terms (and the many others), using the tips to increase your financial knowledge, or tightening up financial reporting, successful leaders ensure these characteristics are not contained within the walls of their accounting departments, but instead, are a part of their entire company culture. With financial clarity, you can maintain stability to carry out the company’s mission.
Simply, when you understand the financial terms and their effects on your business, it not only helps your bottom line, but also helps you have a more constructive (and potentially profitable) conversation with potential bankers and investors.
Let Mindy Barker & Associates show you how to raise your knowledge and be prepared for that next big conversation. We can help you improve your financial brilliance and empower you with the tools and financial information you need to improve your company value, cash flow, and profitability. Schedule a 30-minute free consultation here to learn how.