How to Understand Business Finances

How to Understand Business Finances.

Business finances can seem overwhelming, especially if you’re a new business owner. Fortunately, things like accounts receivable, accounts payable, cash flow, and gross margin aren't actually as complicated as they might seem. Start by learning some basic terminology and how to calculate the revenue and profit for your business. Then, learn how to easily track your finances using things like balance sheets and income statements. Once you’ve got these basics down, you’ll be well on your way to successfully managing your business’ finances.



Method 1 Understanding Revenue and Profit.

1. Add up the total amount you’ve earned in a given period to find your revenue. Revenue is the total dollar amount that your business has earned in a given period of time, like one month. This isn’t how much money you’ll be pocketing as a business owner though. It’s just the total amount of money you’ve brought in, before subtracting expenses.

Imagine you own a lemonade stand. If you sell 100 glasses of lemonade for $1 per glass in a month, your revenue for that month would be $100.

2. Total how much you spent on materials and labor to calculate your COGS. COGS, short for cost of goods sold, is the total amount you spent on materials and labor to produce your goods or services. This is the money you’ve invested into creating the product or service you’re selling.

The COGS for your lemonade stand would include the cost of lemons, cups, and sugar.

Say you need 50 lemons, 100 cups, and 25 cups of sugar to make 100 glasses of lemonade. If lemons are $.25 each, cups are $.10 each, and cups of sugar are $.15 each, that means your COGS would be $26.25.

Only direct labor is included in COGS. Direct labor is labor that’s directly related to the production of your goods or services. Paying someone to advertise your lemonade stand on social media wouldn’t be considered direct labor (because it’s not directly tied to the production of your lemonade), so you wouldn’t include that in your COGS.

3. Subtract COGS from revenue to find your gross profit. Gross profit is equal to the revenue your business is bringing in minus the cost of your goods sold (COGS). Gross profit shows how much money your business is earning after subtracting direct labor and material costs, but it doesn’t factor in other expenses.

If the revenue for your lemonade stand is $100 and the COGS is $26.25, your gross profit would be $100 - $26.25, or $73.75.

Tracking gross profit over time can help you notice periods where your business is less profitable so you can make changes if necessary.

4. Subtract expenses from gross profit to calculate your net profit. Net profit, also known as your bottom line, is the total amount your business brings in over a given period (revenue), minus expenses and COGS. This is the amount of money you have leftover after factoring in all of your expenses. You can pocket this money or reinvest it in your business.

Expenses for your lemonade stand would include things like printing posters to advertise your stand, buying a wagon to carry your supplies, and paying a friend to help pass out your posters.

If your lemonade stand expenses add up to $30, you would subtract $30 from your gross profit, which is $73.75, and get $43.75. Therefore, your gross profit is $43.75.

5. Use revenue and COGS to calculate your gross margin. Gross margin is the percentage of every dollar you make that is profit. The higher your gross margin is, the more profit you make with each sale. To find your gross margin, subtract COGS from revenue, then divide that number by your revenue.

To calculate the gross margin for your lemonade stand, first you would subtract $26.25 (your COGS) from $100 (your revenue) to get $73.75. Then, you would divide $73.75 by $100 to get 0.73. Therefore, your gross margin is 73%, which means 73% of every dollar you make is profit.



Method 2 Tracking Your Business Finances,

1. Use an income statement to keep track of your profit. An income statement, also known as a profit and loss statement or “P&L,” shows the revenue, expenses, and net profit for your business in a given period. Income statements are usually prepared either monthly or quarterly.

The income statement for your lemonade stand would include how much you spent, how much you earned, and your net profit or loss for the month.

2. Keep a balance sheet that shows the financial status of your business. A balance sheet shows the financial status of your business at a given time. It should include your assets, or things your business owns that are of value, and your liabilities, which are your financial debts and obligations. You can use your balance sheet to determine how financially healthy your business is. Ideally, your business should have more assets than liabilities.

Your lemonade stand’s assets would include things like the wooden stand you own and how much cash is in your register. Your liabilities would include payments you’re making on the wagon you use for your business. All of these things would be included on your balance sheet.

3. Measure your cash flow each month. Cash flow is the movement of money in and out of your business within a given period, like one month. You can find your cash flow by comparing the amount of money your business has at the beginning of the month to the amount is has at the end of the month. Ideally you want a positive level of cash flow, which means that more cash is coming into your business than going out.

Use your cash flow to determine when you should spend more money on your business. If your lemonade stand has more money available at the beginning of the month, you might choose to buy more supplies at the beginning of the month instead of the end.

4. Track your accounts receivable and accounts payable. Accounts receivable is money that’s owed to your business, while accounts payable is money that your business owes to its creditors. Keep track of this information along with your income statement and balance sheet so you know exactly what you're owed and who you owe money to.

If your lemonade stand starts offering a promotion where customers can pay a monthly fee to get unlimited lemonade, you would include those monthly payments in your accounts receivable.

If you have fresh lemons delivered daily by a local farm, you would include your monthly lemon bill in your accounts payable.



Tips.

Tracking different financial metrics like revenue and net profit can give you a good sense of how your business is doing over time. If your revenue is continuing to grow, that's a good sign. However, if you notice your revenue dropping consistently, that's a sign that something could be wrong.