10 Finance/Accounting Lessons For Small Business Owners
Every Small Business Owner gets to understand that finance and accounting are two critical elements in the language of business. While he or she does not need to be an expert in either of these disciplines, an above average demonstration of intelligent ignorance in both of them is necessary for entrepreneurial success.
The good news is that the Small Business Owner doesn’t need to be a genius to acquire the competence to appreciate the flows and ebbs of business. Here are10 finance and accounting terms that a Small Business Owner should know:
1. Cash Flow: This is cash that flows into and flows out of the business, through trading activities, in a given period, say a month, quarter, half-year or full year. It is the difference between the cash available at the start of a period and the cash at the end of the same period. It is positive when the closing balance is higher than the opening balance, and negative when the reverse occurs.
Whereas cash comes into the business from customers as payments for products sold or services rendered, it goes out through such expenses as production costs, staff salaries, taxes, etc.
Cash, as they say, is the lifeblood of the business. Hence it is important to keep a regular schedule of the cash that flows in and out of the business. A monthly focus on cash flow gives the Small Business Owner an overview of the components of the business that impact on its cash flow, shows how each component affects the business and makes it easy to foresee and avoid a cash flow crisis.
Cash flow may be increased by one or a combination of these actions: Sale of more goods or services, selling assets, cutting costs, increase of selling price, faster collection of receivables, slower settlement of payables, raising more equity or getting a loan.
2. Accounts Receivable: Accounts receivable are monies owed to the business by its debtor-customers. Originating from goods sold or services provided on credit, they reflect the current asset account of the business. They are legally enforceable claims for payment which the business holds for goods supplied or services delivered to customers but have not been paid for. They are usually in the form of invoices raised by the business, delivered to customers, and due for payment within agreed times.
A Small Business Owner who sells goods or services on credit must track who owes how much and when each outstanding is due. An effective accounts receivable system must therefore include sending timely and accurate invoices, verifying balances, posting paid invoices, generating reports and matching/updating of records.
3. Accounts Payable: Accounts payable are monies owed by the business to its creditors. They represent the current liability account that tracks payments and expenditures that have fallen due, or are about to be due for settlement; like staff salaries, purchase orders, invoices, marketing costs and other expenses that the business has to pay for.
The Small Business Owner must expertly manage the accounts payable of the business through information management, organising and prioritising, accuracy and attention to details, vendor relationships and sticking to deadlines.
4. Gross Profit: Gross profit is the money that remains after the business has deducted the cost of making a product or providing a service that has been delivered to its customers at a price. It is calculated by subtracting the cost of goods sold from the revenue that accrued therefrom, and recorded in the income statement of the business.
Gross profit is a measure of the profitability, or otherwise, of the business. The Small Business Owner strives to reduce cost of goods sold and related operating expenses, because he or she expects the gross profit to cover the cost of running the business and leave a surplus for growing it.
5. Profit and Loss Statement: Often referred to as the net income statement, the profit and loss statement summarises the revenues earned, and the costs incurred, by the business within a period. It is the report card that tells whether the business is making money, breaking even or losing money.
An accurate profit and loss account gives the Small Business Owner the information he or she needs to know how well, or badly, the business has performed during a trading period. It provides a framework for making informed and wiser decisions, and planning for the future.
An understanding of the profit and loss statement helps the Small Business Owner to focus on the goal of the business; that is, maintaining its financial health, by bringing in more cash than it is paying out.
6. Collateral: This is a tangible or intangible asset used to secure a credit or loan for the business. An asset pledged as collateral can be seized by the lender if the business fails to meet the terms of the transaction.
It is noteworthy that through the National Collateral Registry created by the Central Bank of Nigeria, Micro, Small and Medium Enterprises (MSMEs) can now register and leverage movable assets as collateral for bank loans.
The National Collateral Registry, launched in May 2016, led to the establishment of the Secured Transactions in Movable Assets Act, 2017.
7. Credit Report: A business credit report details the credit history of the business, as prepared by a business credit reporting agency.
Three Credit Bureaus (CRC Credit Bureau Limited, CR Services Credit Bureau Plc and XDS Credit Bureau Limited) started business in 2008 under licence of the Central Bank of Nigeria (CBN).
The Credit Bureaus provide Credit Reports on customer, do quarterly Portfolio Monitoring Report and issue Credit Scores. Lenders are expected to use their reports in evaluating loan applications from businesses.
8. Line of Credit: A line of credit, also known as overdraft, is a credit facility given by a bank or other financial institution, and available for the business to draw on according to pre-set limits. The business is allowed to draw from the line of credit when it needs it, up to the agreed maximum amount. The business pays interest on the amount it draws down.
A line of credit is a revolving and open-ended loan. The business is allowed to pay back the amount used and could draw down again. The periodic interest charges rise or fall in line with how much the business draws down. This line of credit could also be secured or unsecured.
A line of credit provides a quick source of working capital for the Small Business Owner. Because it is flexible, unlike the traditional loan in which the business borrows a lump sum of money upfront, a line of credit helps the Small Business Owner to manage cash when cost are unpredictable.
9. Credit Terms: The credit term is the agreement between a seller and buyer, and lists the times and amounts of payments the buyer will make at a future. It is the contract that specifies what the seller requires, which the buyer must meet to make a credit purchase.
Typical credit terms offered by a seller to a buyer will spell out the monthly and total credit amount, maximum period for repayment, discount for cash or early payment, and penalty for late payment.
As used here, credit terms relate to seller-buyer agreements as distinct from lender-borrower agreements.
10. Personal Guarantee: A personal guarantee is a legal promise by the Small Business Owner to repay credit issued to the business, if the business is unable to repay the debt.
The personal guarantee is a financing chore that Small Business Owners love to hate. While it is unsecured to the extent that it is not tied to a specific asset like a residence, the act of making the Small Business Owner a co-signatory to the borrowing puts his or her assets at risk. The creditor will go after the Small Business Owner, and all that he or she has, if the business fails to repay the loan.
By learning and internalising the above-listed concepts in finance and accounting, the Small Business Owner can develop a knowledge base for asking probing questions and getting the practical answers that are essential for building a healthy business.