Top 5 Financial Concepts Every Entrepreneur Needs to know
As an entrepreneur, you’re asked to know a little about a lot. That includes finance. As you run a small business, you’ll run into all kinds of financial lingo. We’ve put together a dictionary of the most important financial terms and concepts that every business needs to know. This guide will get you up to speed, defining terms like debt-to-equity ratio and EBITDA, and explaining how and when you’ll need to use them. We’ll also link out to more robust guides if you want to deepen your understanding
Table of content
- Return on investment
- Return on advertising spend (ROAS)
- Working capital
- Profit margins
- Cost of good sold
1. Return on investment(ROI)
Return on investment (ROI) is a calculation used to determine whether or not an investment is profitable. ROI is used in two ways to determine the estimated return of future or current investment and as an analysis too after the fact to determine how profitable the investment was
Ways ROI can be expressed
ROI can be expressed in 3 different ways:
- As a ratio
- As a percentage
- As a multiple ( i.e 5x or 10x, most commonly used when ROI is greater than 100%)
ROI formulas
There are 2 ways to calculate ROI. Both will give you the same result. It’s just a matter of preference in the calculation method:
1 ROI = Net profit/ Cost of investment * 100
2 ROI = present value – cost of investment / cost of investment * 100
2. Return on Advertising Spend ( ROAS )
Return on advertising spending (ROAS) is a financial ratio that calculates the profitability of your advertising. ROAS is like a more focused version of ROI and it’s calculated similarly. The main difference is that ROAS specifically measures the profitability of ad spending
How to calculate ROAS
ROAS = Gross Revenue from Ad Spend – Advertising Cost
What is a Good ROAS?
A ROAS of 4x( aka 4:1 or 400) is considered the typical benchmark for online advertising spending. That said, what makes a good ROAS varies from business to business. Some businesses will need a much higher ROAS to remain profitable, while other businesses can handle a lower ROAS while maintaining profitability. E-commerce businesses, for example, can typically carry a lower ROAS because they don’t have the additional costs associated with brick-and-mortar retailers.
3. Working Capital
Working capital or cash flow, refers to the liquid capital a business has. Working capital can be calculated in 2 ways, either as the net working capital ratio (calculated by dividing your current assets by your current liabilities) or net working capital (calculated by subtracting your current liabilities from your current assets.
Working Capital Formulas
Net working capital = current assets – current liabilities
Working capital ratio = current assets/ current liabilities
The goal of calculating working capital is to help you assess if you have enough cash on hand to cover a given expenditure. As a result, you want to limit the assets that you include in your working capital to your short-term assets like the cash you have on hand (i.e in your business bank account) and account receivable that you expect to convert within the next 12 months
What should you include in the current liabilities for your working capital calculation? You’ll want to include salary, taxes and account payable (outstanding balances owed to vendors, credit card balances, etc)
Reasons you might need or want extra working capital
- To take advantage of bulk discounts from suppliers
- To meet an influx of bills from vendors
- To cover tax, employee salaries and other costs during downturns
- To acquire another business
4. Profit margins
Profit margin is one of the commonly used metrics for determining small business profitability. The higher your business profit margin, the more flexibility you’ll have, but on the flip side, the pursuit of profit for profit’s sake can reduce the quality of your products/services (which can create a series of other challenges). For small business owners, the goal is to find the ideal balance between profit margin, quality, and other company values ( like sustainability, community investment, etc)
Types of profit margin calculations
There are 3 types of profit margins. All of them measure profitability differently and have their benefits. The best way to know which one you’ll want to use is to determine how you want to use it. We’ll walk you through the business cases where each profit margin type is most useful.
- Net profit margin: Your net profit margin provides a sense of the company’s profitability about your expenses.
- Gross profit margin: Your gross profit margin can be used to evaluate pricing strategies, production processes, and manufacturing efforts.
- Operating profit margin: your operating profit margin will give you a sense of how profitable your business is after materials and wages. Your operating profit margin gives you a sense of how profitable your business is day-to-day
How to calculate your profit margins
Each of the 3 profit margin types has its formulas
Net Profit Margin= (Net Profit / Net Revenue) * 100
Gross Profit Margin = Gross Profit/ Total Revenue
Operating Profit Margin= ( Operating Income/ Net Sales) * 100
How to use Profit margin effectively
Your profit margins can act as your North Star to guide other business decisions. When you’re regularly checking on your profit margins, it will predict other important financial metrics, like your working capital. To get the most out of your profit margin metrics, you want to regularly check up on them. Various factors throughout
The supply chain strain in 2021. By regularly checking your net profit margin, you can avoid negative surprises in your end-of-end
5. Cost of goods sold (COGS)
Cost of good sold, or COGS, refers to the specific costs related to the direct sale of products – including inventory, packaging, labour production costs, and raw materials. Your COGS is a foundational expense calculation that can be used to calculate other important business metrics. For example, your COGS can be used to calculate your gross profit (by subtracting COGS from sales revenue)
What’s included in Cost of Goods Sold (COGS)
Your Cost of goods calculation will be dependent on your business’s specific products and expense types. Here are some common examples of what might be included in your COGS:
- Shipping
- Direct labour
- Raw materials
- Distribution costs
- Finishes products for resale
- Items needed to sell a products