In a nutshell: Even if you’re not part of the finance function at your organization, you’ll benefit from knowing these basic concepts.
Note: This is the first article in a series about small business finance and accounting.
To excel in any area, it’s important to first understand and master the basics. This is true in everything from engineering and architecture to modern art and coaching a sports team.
It’s also true for small business owners. Finance skills provide the foundation upon which you can build a stable business.
Yet many entrepreneurs may not have a thorough understanding of the basics of finance. Much like those who don’t have a firm handle on their personal finances, it can be a recipe for disaster.
Some of that is the consequence of there being no one path to becoming an entrepreneur. A quality business degree program covers accounting and finance basics, but not all small business leaders take such courses.
The following offers an informational introduction to small business finance basics, even for those not involved exclusively in a finance role. It’s meant to provide an overview. You should always consult with a professional before making any major business decisions.
In a separate article, we will look at the detailed areas of accounting that are essential to business success — and the red flags that show potential trouble looming on the horizon.
Why Basic Finance Skills Are Important
Most adults have at least a basic understanding of their personal finances. The ability to make a personal budget, track spending, save money for future purchases, invest early, understand your tolerance for risk, calculate your net worth regularly and plan for retirement can all lead to a better life.
The same is true for small businesses. Issues such as hiring employees, making equipment purchases and expanding into new markets all require skills in business finance.
Small business finance typically breaks down into five principal areas. They are:
- Startup costs
- Future growth
Here’s a closer look at all five.
Entrepreneurs need sharp finance skills when looking at ways to fund their startup.
Starting a company is the first step in the business life cycle, and the one where the money coming in is not likely to match the money going out.
Navigating this time requires forecasting on costs (hiring employees, creating the product or service, financing the purchase of equipment, renting office space) and income over the first year or two. Diving into a new business without projecting these numbers can end in failure – it is one of the reasons that 30% of businesses fail in the first two years, and 50% fail within five years, according to the U.S. Small Business Administration (SBA).
Small business loans are perhaps the most important thing to understand in this area. Typically, loans or investment money is necessary to start a business. The options include:
- Investors: There are a wealth of “startup accelerators” and individual investors willing to back a new business that has a smart plan for success. This can also include your family and friends
- Term loans: A loan, typically from a commercial bank, with a fixed or variable interest rate. The period for repayment of the loan typically ranges from one year to as many as five.
- SBA loans: The SBA provides access to loans and adviceto new businesses — essentially, the government agency does not loan money directly, but backs and guarantees your loan to a commercial lender
Once your business is off the ground, business operations typically follow a cycle. You invest your money into the facilities, equipment, materials and employees needed to make a product. You sell the product to a customer. That money comes back into the company, and you start the process again.
Simple! Yet, it’s vital to have an accurate estimate of your operational expenses and potential revenue. It pays to be conservative. Some business owners will inflate projected revenue to cover high operational costs. Having an accurate estimate of your ongoing operational expenses and realistic revenue projects are both critical.
A budget is like an exercise and diet regimen. Eating right and exercising regularly keeps you on track to good health. A solid small business budget keeps you on track for consistent profitability.
A small business budget is not meant to track every penny, but rather provide a guide to help you make better financial decisions and offer insight into areas where you can make improvements.
Some tips to keep in mind when budgeting, according to Forbes, include the following.
- Know Your Organization: Understand the business cycle of your enterprise and budget accordingly. For example, many businesses are seasonal in nature, with fluctuating periods of both revenue and expenses. It’s important to separate fixed costs (your rent or loan payments, for example) from variable costs (such as the cost of materials to build your product)
- Build a Team:You should not go it alone with a budget. Bring in key people for your budgeting team and hold them accountable to the budget you develop.
- Realistic and Conservative: As mentioned above, business finance is not an area to make pie-in-the-sky projections. Use past data to build a solid budget foundation, not wishful thinking.
- Be Flexible: A budget is not carved into stone. Make changes as new factors enter the picture during the month or year.
- Be Detailed:Again, you don’t have to track every penny. But it’s wise to break down your budget into areas that make sense. Get detailed in such areas a payroll, equipment and materials, for example.
The SBA provides valuable tips in this area. Entrepreneurs can also search Google for small business budget templates.
In a well-run operation, this should prove a straightforward task. Most businesses require at least monthly internal reports on expenses in each budget area and revenue. Properly reporting revenue and paying quarterly taxes is a breeze if you accurately track the money coming in. We will take a more detailed look at the areas you should be tracking in a future article in this series.
Now that your business is funded and running smoothly, the next step is to plan on how to expand your business. As the SBA numbers show, 50% of business fail within five years. Of those, 29% fail because they ran out of cash.
That makes the period between initial success and five years of operations a critical time.
Growing revenue is the best path to success, but it typically requires further investment in operations (employees, equipment, materials, etc.). But without the cash flow to finance an expansion, how can a small business owner accomplish this goal? There are two overall methods: loans and grants.
As noted above, you may be able to obtain a loan backed by the SBA. The agency’s SBA’s 7(a) loan program is the most popular. Overall, SBA backing can lead to a longer loan repayment period with a smaller down payment. This may vary depending on business, industry and individual circumstances
Commercial lenders such as banks and credit unions will typically need to see a business plan, financial statements, both personal and business tax records, personal financial statements, past loan information, current business leases and financial projections before considering your loan application.
Grants also can fund growth. And unlike loans, they don’t have to be repaid. Grants are available through the federal government, many states and some local governments, and private organizations. The Grants.gov site is a good place to start.
These are some of the small business finance issues you will need to understand for success as an entrepreneur. Small businesses remain the bedrock of the economy in the United States. Success as an entrepreneur is entirely doable, but learning the finance basics is essential.