Finance is at the core of every business- there is no denying that. However, while large businesses can afford to have the best finance gurus to keep tabs on the money, small businesses often have to learn a lot of these things through trial and error. There are many moving parts in the finance management system which is why it can be overwhelming to keep everything under control.
Here are five small business finance basics that you should understand to run your company efficiently:
1. Profit Margin
The first thing to understand about margins is that they are of two types- gross and net. The former is used to measure the profitability of a single commodity. So, if it costs you Rs. 2000 to make a product and you are selling it at Rs. 2500 then your gross margin is Rs. 500. Most small businesses use gross margin as a metric for their profits. However, looking at the big picture it isn’t of much use, and here net profit margin comes into effect.
Net profit margin is calculated by deducting all of your business expenses from the total sales and dividing that figure by the total revenue. So, if you generated Rs. 3 lakh in revenue last year, and your total expenses were Rs. 1 lakh then your profit margin can be calculated as:
Profit margin= (300,000-100,000)/300,000 = .66, or 66%
It is important to note that profit margins are industry-specific. Thus, you will find that business owners in some industries make more money than those belonging to other industries. For instance, many big food companies have net margins of just 4% or 5%. However, consultancy companies can have way higher margins, because the overhead there is little.
When you start your business, your margins are usually high, but as it scales you have to buy more equipment and hire more staff, which eventually lowers the gross margins. However, the net margin is what matters at this point, and it can increase if you make the right business decisions.
2. The Balance Sheet
Balance sheets serve as a financial dashboard for your company which you can refer to at any point to time to get a quick understanding of where you stand financially.
There are three main components of a balance sheet, which are:
There are mainly two kinds of assets: current assets and non-current assets. The former are most likely to be converted into unrestricted cash within one business cycle (12 months in most cases), but the latter will not. Inventories, accounts receivables, etc. are considered as current assets.
If you have a large number of assets or cash on your balance sheets then you can attract investors easily. This is because these can be used for protection in rough times or for scaling the business in future.
Just like assets, liabilities are of two types: current liabilities and non-current liabilities. Current liabilities are obligations that must be paid within one business cycle, such as payments pending for suppliers, etc. Non-current liabilities are long-term obligations such as loan debt, etc.
Equity is the ownership interest of shareholders in your company. It can be calculated by deducting total liabilities from total assets. Thus:
Equity = Total Assets – Total Liabilities
Businesses often have to sell equity shares to raise capital for purchasing equipment, making investments, etc. However, each time you sell you lose a portion of your company. Thus, you would want to hold onto to your business as much as possible. Selling an investor 51% or more of your business in equity means giving away the decision power. This can change everything, and thus be chosen only as the last resort.
3. Cash flow
Cash flow is the total amount of money that comes in and goes out of your business. It is one of the most important numbers that you and your stakeholders should know about. Unfortunately, it is often overlooked in lieu of other numbers on the balance sheet and income statement, etc.
New businesses often use the phrase “to be cash flow positive”. It means that you are bringing in more money than you are spending. Similarly, to be cash flow negative means more money is being spent than generated. Or in other words- the business is actually losing money.
It is important to make cash flow projections a part of your budgeting process to stay on top of the financial activities. Not having a sound understanding of how cash flow works can lead to disastrous results. For instance, you can end up waiting for payments from clients while there are several bills to be paid already. There should be sufficient cash flow so that you can cover all the expenses while staying cash flow positive.
4. Business Financing
Funding is one of the major challenges that small businesses have to face. Whether you need initial funding to start a business from scratch, or to meet short-term obligations it is important to get the money from the right source. Making a wrong decision here can have serious repercussions that includes losing a large portion of your company. The following are two of the most common business financing options that you can consider:
Debt Financing: Debt financing is the simplest way to fund a business. It works the same way as any standard personal loan or home loan works. To get a business loan you can simply contact a bank or a P2P lender (which is becoming more popular lately) and submit an application for the same.
Equity Financing: Businesses only go for equity financing when they are unable to get a business loan. This is because while you don’t get debt on your hands in this method you lose something even bigger- a part of your company. You basically sell off your company share to a venture capitalist. So, you don’t have to pay back the money, but the seller becomes a part-owner. Equity financing is also more complicated than debt financing. You have to consult with the existing investors before making decisions and work on the legal aspects of the transaction before finally receiving the money.
5. Payroll Calculations
Payroll processing is comprised of calculation of payments that you make to your employees. Since there are several factors involved the process can be quite complicated.
According to the minimum wages act of India, you have to include some mandatory components in their payrolls, such as Basic (basic salary), DA(Dearness Allowance), and HRA(House Rent Allowance). You also have to make certain deductions from the salaries in the form of TDS (Tax Deducted at Source), etc.
Understanding business finance basics is imperative to a successful business. Without this money management can become complicated and difficult to track. Thus, it pays to get a sound understanding of how the business finance works and use it for making the business decisions.