10 Financial Terms Every Small Business Owner Should Know
- Amortization. Amortization is used in accounting to spread out the cost of intangible (non-physical) assets, such as a patent or trademark, over a period of time. That means you'll pay installments over a designated period and then record the portions of the cost as amortization expenses in your business's books. This process reduces your taxable income over the asset's lifespan.
- APR. APR stands for annual percentage rate. It provides a more accurate total cost to borrow. APR starts with the interest rate, then adds in one-time fees that a financial institution calculates as a percentage point of the total loan. It also includes other potential costs, like closing costs or other fees.
- Cash Flow. Cash flow is the movement of money into and out of your business. Maintaining a positive cash flow is integral to your business's ability to pay debts and ultimately grow your business over time. Managing cash flow by accurately forecasting future seasonal sales slumps, equipment investments, and other variables is critical to your business’s continued success.
- COGS. Costs of Goods Sold (COGS) refers to the manufacturing of physical products and is important to companies that stock inventory when calculating gross profit. It includes costs such as: materials, labor, rent, and utilities, but excludes distribution and sales expenses. Investopedia.com provides a great explanation in their COGS video.
- EIN. An Employer Identification Number (EIN) is a nine-digit number used by the IRS to identify a business. An EIN is needed to:
- Hire employees
- Open a business bank account or start a business line of credit
- Incorporate or form a partnership, an LLC, or trust
- Start a pension plan
- Represent an estate that operates as a business after the owner’s passing
If you're a sole proprietor, you may or may not need an EIN. But even if you don't need an EIN, there are still advantages to having one. It provides a safer alternative than using your Social Security Number and it also helps to clearly identify you as a contractor rather than an employee.
- Financial Statements. According to the SEC, there are three main financial statements:
- Balance Sheets — These should show that a business’s assets equal (or balance) the sum of its liabilities and shareholders’ equity.
- Income Statements — These report revenue and the costs associated with generating that revenue. They are sometimes called Profit & Loss Statements. Income statements also report shareholder earnings per share, if applicable.
- Cash Flow Statements — These report three main activities: operations, investments, and financing.
- Gross or Net Profits. Both types of profits show a business’s performance and ability to produce revenue. Net profit is a more accurate reflection of a business’s profitability, but calculating both can show where savings can be made to increase profitability. A poor gross number would suggest re-evaluating product, marketing, and product costs. A less-than-stellar net would suggest looking at administrative, utility, debt, or other costs.
- Gross Profit $ = Total Sales – COGS
- Net Profit $ = Total Sales – (COGS + Operating Expenses + Other Expenses + Interest + Taxes)
To find the profit margin percentage (gross or net), divide either formula above by the total sales.
- Line of Credit. A line of credit allows you to borrow up to a certain limit, and then only pay interest on the amount of money you borrow. Lines of credit are ideal for businesses in need of working capital. There are two types of lines of credit: secured and unsecured. Secured lines are backed by short-term assets, while unsecured lines don't require any type of collateral.
- Loan-to-Value (LTV) Ratio. This ratio describes the size of a loan compared to the value of the property securing the loan. It's a way for lenders to analyze the risk associated with financing a loan.
- Origination Fee. You may have to pay an origination fee when taking out a small business loan or mortgage. It's essentially an upfront fee the lender charges for handling paperwork and verifying the info in your loan application. It's either expressed as a flat fee (like $500) or as a percentage of your total loan amount (like 5%).