On the other hand, staying on top of your finances is mission-critical. You don’t want to run out of cash so quickly that you need to close up shop, and there are reporting standards that various tax authorities will hold you to. Yes, it’s true that many aspects of managing your business’s money can be handled by transaction tracking software or outsourced service providers, but at the very least, you still need to have a basic grasp of business financial management concepts and terms. After all, finance tends to have a language of its own, and if you’ve never heard the lingo before, these abbreviations and phrases can seem almost alien. Despite their seeming complexity, however, most financial terms are pretty simple to understand. Here are six of the most commonly heard business finance terms and their definitions.
1. IRR
IRR stands for Internal Rate of Return, and it’s a model that helps you figure out the most profitable uses of your money. For instance, if you have a choice of investing in project A or project B, you want to choose the one with the highest IRR. Generally, IRR is easiest to understand when your projects have varying annual cash flows after an initial investment. Excel has a handy IRR function that does the heavy lifting for you. Just make sure you don’t confuse IRR with Return on Investment (ROI) or Compounded Annual Growth Rate (CAGR). ROI measures the overall return over several years, while CAGR uses a beginning and end value to calculate the overall return and then smoothes that value over the interim years. IRR is more useful when intermittent cash flows come into play.
2. AR/AP
AR stands for Accounts Receivable or Receivables, and AP stands for Accounts Payable or Payables. In the business world, AR and AP are extremely important. AR refers to how much money you are owed, and AP is how much you owe. For instance, if a supplier bills you for the products you bought, that invoice becomes a part of AP. The invoices you send to your customers become a part of AR. Ideally, to maintain a positive cash flow, your AR collection times will be shorter than your AP payment times. These times are also called credit cycles. For many businesses, AR credit cycles tend to be long and AP cycles short. This leaves you with a cash crunch. You can use financing options such as short-term loans or invoice factoring (also called receivables financing) to help you bridge the gap.
3. Lien
Liens exist in the personal finance world as well. When you borrow money, you will usually have to offer the creditor some security in the form of collateral. For instance, if you draw a business loan from the bank, the bank will use your business’s assets as collateral. If you default on the loan’s payments, the bank has the right to seize your collateral. This right to seize collateral is called a lien. Liens can be junior or senior. For instance, if you have two mortgages on your property, one of them will be senior. In this instance, the senior creditor gets paid first in the event of a default, and the junior creditor picks up whatever is left. Usually, government liens precede everything else. For instance, if you owe the IRS taxes, those debts precede everything else automatically.
4. APR
APR stands for Annual Percentage Rate. This is the annual interest rate you will pay on your debt. Typically, APR is used in the credit card world. Note that APRs don’t take compounding into account. Let’s say you have an outstanding balance of $1,000 that is past due, and your card has a 20% APR. You might mistakenly think that you’ll owe $200 every year you leave this balance unpaid. However, this isn’t the case. The credit card issuer will prorate the APR over 12 months to calculate your monthly interest payment. Miss the first interest payment, and that amount is added to the debt ($1,000) you owe. Thus, the interest you’ll owe in the following month will increase. The lesson here is that APR isn’t a constant interest figure. It indicates the rate at which your unpaid debts will compound.
5. Gross and Net Margins
Gross and net margins help you measure your business’s profitability. Let’s say you buy raw materials for $5 (costs) and sell them for $10 (revenues). Your gross margin in this case is 100%. The gross margin is a straightforward calculation that tells you how much profit you’re earning once you’ve paid for the cost of the goods you sell. The greater your gross margin, the more wiggle room you have to accommodate other costs. This is where the net margin calculation enters the picture. The net margin is also calculated by subtracting costs from revenues and expressing that result as a percentage of costs. However, unlike the gross margin, the net margin takes all costs into account. Costs such as taxes, interest payments if any, operating expenses and salaries (SG&A) are added to the cost of your goods and subtracted from revenues. The net margin tells you how much your business earns after accounting for all costs. Typically, net margins greater than 10% are considered excellent in the business world. However, much depends on prevailing interest rates and the specifics of your pricing model.
6. P&L Statements
Also called the Income Statement, Profit and Loss statements or P&L statements show you how much you’ve earned over a time period. It summarizes how profitable your business is, and it’s one of the first statements investors look at. This statement also helps investors calculate gross and net margins, since it lists all costs involved in running the business. Note that this statement doesn’t list the cash your business earned, since it includes many non-cash expenses such as depreciation and amortization.
Complicated at First
Business financial terms tend to seem complex at first, but once you reduce them to simple concepts, you’ll find them intuitive to understand. At the very least, every business owner must understand the above six terms if they wish to make an impact on their business.
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