Are you eager to launch a startup or new business? Or were you recently promoted to a financial role in your organization? Either way, you’ll need to master the basics of business finance if you want to find success. Even employees not working directly in finance generally need a basic understanding of it to succeed. Nothing exists in a bubble, and business finance is no different.
Businesses live and die by the quality of their financial planning and performance, as most new companies fail (21.9% within their first year of operation) due to cash flow problems and a lack of demand for their products and services. Besides that, the business finance landscape has gone through many changes as of late.
In particular, traditional business financing options like bank loans have been declining since 2020 — where they fell 6% from 2019 (43% to 37%, respectively). That trend continued in 2021, with only 34% of small businesses applying for bank loans.
Why is that?
The decline is due to the rise of alternative financing methods, such as crowdfunding, fintech platforms, peer-to-peer lending, and ROBS (rollover as business startup). In fact, ROBS is currently the most popular form of business financing in 2023. While this may seem complicated at first glance, it becomes easier to grasp when you understand a few key concepts about financial management.
That’s why I’ve put together this beginner’s guide to business finance, so read on to learn the fundamentals of financing a business.
The beginner’s business finance glossary
“Our P&L report shows that our revenue is now greatly exceeding our expenses, and we’re showing a considerable profit.”
“In the current fiscal year, our liabilities are negatively affecting our equity, so we need more cash flow to pay them off.”
As you can see, the business finance landscape is chock-full of terminology that’s confusing for non-finance people. However, once you understand the following terms, you’ll be able to easily understand the first two sentences in this section. Here’s a look at the most important terms related to business finance.
You may hear someone from your financial department mention the fiscal year, but what does that mean? A fiscal year simply represents the 12-month period that a business uses for its accounting, taxes, and budgeting purposes. The catch is that a business’s fiscal year does not have to line up with the traditional calendar year.
In other words, a company’s fiscal year may start on April 1st and end on March 31st instead of beginning on January 1st and ending on December 31st. However, to avoid confusion, most companies ensure that their fiscal year aligns with the current calendar year. Some exceptions are organizations like school systems, which often align with the school year instead of the calendar year.
So whenever you hear someone talk about their fiscal year, they’re referring to the 12-month period they use for accounting and taxes. Business owners and entrepreneurs use their fiscal year as a way to measure their financial performance. For instance, the fiscal year is often the period used to measure revenue, profit, expenses, debts, and more.
In the business world, an asset is something you use to produce positive economic value. It can be physical, like a vehicle you use to operate your business, or non-physical, such as a patent. A business can choose to liquidate (selling something to convert it into cash) physical business assets, such as real estate, equipment, computers, and vehicles — in order to pay off debts.
However, these physical assets are also subject to depreciation, which means they may be worth less over time due to a variety of factors.
For instance, if you were going to deduct the use of one of your vehicles from your taxes, you wouldn’t deduct its entire value for just one year. Instead, you’d need to ‘depreciate’ the vehicle, enabling you to deduct it from your taxes over its entire lifespan, which may be three, five, or even seven years – depending on the make and model. Also, you need to keep a record of all your business assets on your balance sheet.
In short, a business asset is simply something that your business owns & uses to make money.
Equity (net worth)
What does it mean when someone refers to their business’s equity? Equity refers to the total value of a company’s assets minus the cost of its debts. The original capital that you used to start your business counts toward your equity, as do all your current assets — both physical and non-physical.
In the finance world, equity can also refer to the value stock shares hold from a particular company. Let’s say that your company has $100,000 worth of assets and $20,000 of debt to a venture capital firm. In this scenario, your company’s equity would be $80,000.
Equity is another crucial metric to include on your business balance sheet.
It’s common to hear financial professionals discuss the liabilities their company has, but what do they mean? A liability is a financial obligation that your business owes to an individual, investor, business, or bank. Liabilities include all financial debts that have yet to be paid back.
If the repayment period is less than 12 months, it’s considered a short-term liability. If you have to pay back the loan for more than a year, it’s a long-term liability.
Businesses have to incur lots of expenditures just to operate, including payroll, acquiring assets like vehicles & real estate, and day-to-day expenses (like a restaurant maintaining their inventory of condiments, food ingredients, and beverages). Due to these costs, it’s sometimes necessary for businesses to go into debt to achieve the cash flow they need to survive.
That’s where liabilities enter the picture, and even the largest, most profitable enterprises have to borrow money from time to time.
Expenses, revenue, and profits
These next three terms go hand-in-hand, so I’ve decided to group them together.
First, a business’s revenue refers to the total amount of money it generates, typically due to selling its products and services. Your total revenue will appear on your business’s profit & loss report (more on this in a bit).
Revenue differs from profit in that revenue doesn’t include expenses.
Speaking of expenses, an expense occurs whenever your business spends money on something required to continue your operations. It could be that you need to spend money on office supplies, lunch meetings, gas reimbursement, or a million other things.
The good news?
These types of business expenses are often tax deductible, which is a bonus.
However, to calculate your total profit, you’ll need to subtract your expenses from your total revenue.
So if your business brought in $200,000, but you spent $50,000 in expenses, your total profit would be $150,000.
Maintaining a balance sheet is a necessity for any sized business, so it should definitely be a part of your bookkeeping process.
Small business owners should create a balance sheet that contains the following:
A complete list of your business assets.
All your current liabilities.
Your total equity.
Debt ratio (comparing total assets to total debts).
Data from the previous year.
Balance sheets are invaluable for conducting financial analysis and making key financial decisions at a business. That’s because you can quickly compare and contrast your business’s financial performance over several years by analyzing your balance sheets. You can also use your balance sheet for future forecasting, namely by pointing out your top areas for improvement (profit, equity, etc.).
Profit & loss report
If you’ve ever heard anyone mention a P&L report, they’re talking about a profit and loss statement. While balance sheets deal with assets and liabilities, P&L reports are all about revenue, expenses, and profit.
In particular, they let you know if your business saw a profit or loss during a given fiscal year. Both balance sheets and P&L reports are essential for audits in order to make better business decisions, so you should use them both.
Business financing sources
Now that you know more about essential business finance terms, it’s time to learn how to finance a business from scratch.
After all, if you wanted to start a business, how would you acquire capital?
Here’s a look at the most popular ways businesses get financed these days.
Financing a business with debt refers to taking out a small business loan from a bank. Just like personal finance, requesting a loan involves a credit check where the bank looks into your credit history. Acquiring a loan is no guarantee, so businesses need to have all their ducks in a row to receive approval.
It also depends on the health of the economy, as banks are less willing to give out business loans during recessions.
What are the advantages of debt financing?
The biggest perk is that the bank has no say in how you run your company. Once you pay off the loan, you’re done with them forever — and you’re free to run your company as you see fit.
The drawbacks are that you have to pay the loan off, which can be easier said than done — especially if the loan agreement has a high-interest rate.
Besides heading to the bank, you can choose to acquire working capital from investors instead. This is known as equity financing, where investors provide capital by purchasing partial ownership of the company (via stocks and shares).
There are two primary types of investors: venture capital firms and angel investors.
Venture capital firms invest in new businesses they believe will provide returns down the line. The dealings are often very complex, and the investing is usually handled by a firm instead of an individual.
Angel investors are individuals that provide capital for smaller projects they believe in and often have simpler terms.
The primary perk of equity investing is that you don’t have to pay the money back. As such, your business is likely to have more cash on hand.
However, your investors own part of your company, which means they’ll have a say in how you run things.
So if you don’t like working with partners, equity investing isn’t the way to go.
Next is a hybrid between equity and debt financing. Mezzanine capital is when a bank initially agrees to finance a loan, with the stipulation that they’ll take partial ownership of the company should the business fail to pay.
Banks are more likely to go for mezzanine deals because there’s less risk involved for them. If you’re unable to repay the loan, they’ll acquire stock in your company.
Rollover as Business Startups (ROBS)
As stated in the intro, ROBS have become more popular than small business loans to finance businesses.
What is a ROB?
It’s where an individual uses their personal funds, usually from their retirement fund or 401k, to finance their business tax-free. ROBS are popular for entrepreneurs that have considerable 401ks or retirement funds and don’t want to take on any debt. They also work for individuals that don’t qualify for other forms of financing.
It’s a more independent way to finance a business, but it’s not without its risks.
Primarily, if your business venture fails, you’ll lose your entire retirement fund/401k.
Another form of business financing that’s exploded in recent years is crowdfunding.
It’s where you rely on donations from the public to fund your business. Websites like Kickstarter, Patreon, and Crowdfunder have made this type of business financing possible for the majority. It works by gathering donations from individuals who want to see your business succeed — usually by providing something they want.
Popular video games, inventions, and other types of companies were able to find funding using this route. Besides gathering donations off the power of the business idea, crowdfunding also works by providing perks to donators.
That could be as complex as owning stock in the company or as simple as providing merch like t-shirts.
Wrapping up: A beginner’s guide to business finance
While the world of business finance may seem intimidating at first, it’s actually not too complicated. Once you understand what common terms like equity, liquidity, cash flow, revenue, and profit mean — everything gets a lot easier.
The business finance landscape is also going through significant changes, with more small businesses using ROBS and crowdfunding for financing instead of banks and investors.