Typically, you do not have to be a financial expert to start a business. But, once you start a business, it is inevitable that you will run into these financial lingo every now and then. It may come when you are trying to put together a financial report, seek some loan or other business credits, or even pitch to investors.
It is necessary to have a basic understanding of some of these terms so that you are not caught unawares. Here are 7 key financial terms that you may keep running into every now, and easy ways to calculate them even if you have no background in financing.
Return on Investment (ROI)
Return on investment (ROI) is one of the most common financial terms for business people. In fact, it is used across different kinds of businesses and investments, both physical and digital. The Return On Investment (ROI) is used to illustrate or predict how profitable an investment should be in a given period. Or how profitable a business investment has been over a past period.
This means it can be used for predictions as well as evaluations and analyses. This metric will help you decide whether to buy that equipment, embark on that marketing campaign, launch that product, or open a physical outlet. It tells you if the profit will be worth the time and resources you inject into it.
Here is how to calculate the ROI.
For physical product, ROI = ([Present Value – Cost of Investment]/Cost of Investment) x 100
For campaigns and other investments, ROI = (Net Profit/Cost of Investment) x 100
Working capital is different from Capital. Working capital refers to the amount of liquid capital a business has at every point in time. So if you have some of your total capital tied up in assets, it does not count as part of your working capital because it is not readily available.
Why would you ever need to calculate working capital? to determine if you have sufficient liquid capital to embark on a project or major expenditure in the business. Regular calculation of working capital should give you a picture of the financial health of your business, and see how your working capital is growing month-on-month or otherwise. It will also help you understand if you need to raise extra working capital for that next big move.
Here’s how to calculate your working capital.
Net Working Capital = Current Assets – Current Liabilities
Working Capital Ratio = Current Assets / Current Liabilities
Common as this may sound, it is commonly misunderstood. The profit margin is an indicator of a business or a product profitability. Even though one is not supposed to pursue profit for its sake, the profit margin calculation can show you what products or businesses you need to drop. This indicator tlls you how profitable your business is after materials and wages.
It is often calculated in percentages, and you can calculate gross profit margin, net profit margin and operating profit margin. Net profit margin shows your profitability in relation to your expenses, while gross profit margin shows the profitability in relation to production processes, and manufacturing efforts.
Net Profit Margin = (Net Profit / Net Revenue) x 100
Gross Profit Margin = Gross Profit / Total Revenue
Operating Profit Margin = (Operating Income / Net Sales) x 100
Revenue refers to all cash inflows. All monies generated by a business are a part of its revenue. It is not an indicator of profitability as it does not account for expenses, but it can show much about a business’ ability to generate sales, and the amount of demand a business has to fulfill. A business may be generating a huge revenue without necessarily being profitable. A lot of company financials can reveal quarters where they generated revenue but still made a loss.
The only way to calculate revenue is to sum up all cash inflows.
In its simplest form, valuation says “what are you worth”. It places a value on your business, and you will mostly need this when you are seeking investments or some form of credit. However, you can also choose to regularly value your business, just to keep tabs on your growth stages and stay motivated. Surely, knowing that your little business of yesterday is now worth $5,000 can be a huge motivation and a reason to stay on when things get tough.
There are several ways to value your business, and one very common way is by valuating all of your businesses tangible and intangible assets, and putting these figures together (also factoring liabilities like loans). Another way is to look at the monthly earnings of the business over the past period.
Debt-to-Equity Ratio (D/E)
How does your debt compare with the business equity? Are you running the business with borrowed funds or with owned funds? That is what this term answers. It is a calculation that compares the business liabilities with the owner(s) equity. It may also be referred to as risk ratio or leverage, and it tells how much risk the business faces.
Debt-to-Equity Ratio = (Short Term Debt + Long Term Debt + Other Fixed Payments)/ Shareholder’s Equity
A fiscal year is an accounting year is the set calendar (52/53 week period) which a business runs with. This may not necessarily be January to December for all businesses. Some businesses (including some banks) run a fiscal year that starts in April of one year and ends in March of the next year. This is what they use for tax purposes and other financial calculations.
Customer Acquisition Cost (CAC)
Customer acquisition cost (CAC) refers to the amount of capital a business spends to acquire a new customer. CAC includes the total amount of sales and marketing resources dedicated to acquiring that customer, along with related property or equipment that you need in order to make the sale and convert the customer. With the use of targeted online advertising, it is now possible to get a more specific CAC
Again, this is an indicator of business profitability, and even as you strive to get more customers, you want to keep the cost of acquisition as low as possible. To calculate this term, you factor in your advertising spend, inventory costs, Marketing team salary/pay, Sales team salary/pay, production cost, creative cost. When you sum all of these up, you divide it by the total number of customers acquired during the period. This gives you the Customer Acquisition Costs per customer.
CAC = (Cost of Sales + Cost of Marketing) / Number of Customers Acquired