If you’re new to business, you may feel overwhelmed by all the financial terms and metrics that pertain to your enterprise. From cash flow to profits, here are the ten most important finance metrics all entrepreneurs should know and understand about their business, writes former Flying Solo editor, Kelly Exeter.
It’s been said that where your attention goes, energy flows. It’s easy to pay attention to new enquiries and requests for work in our inboxes and assume if we’re busy, then our finances are probably in good shape. But this is often not the case.
Further, it’s hard to give our attention to things we don’t properly understand. Unless you have a natural affinity for all things numbers, there’s a chance you’re not across key financial metrics relevant to your business. (Or keeping an eye on what they’re telling you about how your business is travelling.)
With a new financial year starting soon, let this be the year you resolve to pay greater attention to your business numbers. Let’s see what difference it makes to your business when some energy flows in that direction.
Know your numbers
To help you get started, here are ten financial metrics and terms every business owner should understand.
1. Revenue
Revenue is the total income (gross income) a business makes.
Is revenue different to ‘sales’? While these terms are often used interchangeably, they are technically different. Sales refer to the income generated by a business’s products and services. Revenue covers all sources of income, including things like interest, royalties, etc.
2. Monthly recurring revenue (MRR)
MRR is the predictable revenue generated by your business each month.
Common drivers of MRR are things like subscriptions (software companies, streaming platforms like Netflix, newspapers and magazines), service agreements/support contracts (web hosting, IT services) and retainers (lawyers, consultants).
Because MRR is stable income that can be counted on to come in each month, it helps you create accurate cash flow and budget forecasts and make business decisions confidently.
3. Fixed costs
Fixed costs are business expenses that remain constant regardless of whether revenue is being produced (i.e. have to be paid whether you’re making sales/generating income or not).
These costs are like MRR – they are predictable and stay the same each month.
Common fixed costs are things like rent paid on your business premises, salaries (depending on the industry) and insurance.
4. Variable costs
Variable costs change in proportion to the number of goods or services you sell. If you’re a café doing a roaring trade on Sunday, the cost of buying milk that day will be higher than it would on a quiet Monday.
5. Gross profit
In simple terms, ‘profit’ refers to the financial benefit gained when revenue is more than costs/expenses.
In business accounting, it’s essential to understand the difference between gross profit and net profit because they tell you different things about your business.
Gross profit is the money generated from selling a product or service after any direct costs (cost of sales) are taken out. It’s a crucial first step in running a profitable business. If your goods and services cost you more to produce than you’re selling them for, you’re not generating gross profit.
For example, let’s say you’re a cake maker, and the cost of ingredients and materials involved in baking a fancy wedding cake is $300. If you charge the happy couple $250 for the cake, you’ve made a $50 loss on that cake. If you charge $350, your gross profit is $50.
6. Net profit
While gross profit speaks to the profitability of the goods and services you are selling, it doesn’t give a complete picture of the financial profitability of your business as a whole. Net profit does.
Say our cake maker sells 1,000 cakes in a year at $350 per cake, and the cost of making each of those cakes is $300. Their gross profit for the year will be $50,000.
But what’s their net profit?
If that cake maker uses their kitchen at home and equipment (mixer, oven) that has already been paid for, their fixed costs would be minimal, and their net profit could be close to $50,000. But if the cake maker is paying $30,000 a year to hire specialised equipment for their cake-making activities and someone to help ice the cakes, their net profit would be $20,000.
Net profit is an important number as it indicates whether your whole business is profitable (as opposed to just the products in your business).
7. Net profit margin
While it’s nice to be running a business that turns a profit, net profit is just a number. It tells you there’s money left over from the revenue you’ve generated after you deduct all the costs and expenses of running the business, but not much else.
On the other hand, net profit margin measures how much a company keeps in earnings from every dollar it generates.
The net profit margin calculation looks like this:
- (Revenue – Expenses) / Revenue = Net profit margin
Let’s go back to our cake maker, who made a net profit of $20,000 for the year.
Their net profit margin would be calculated as follows: ($350,000-$330,000) / $350,000 = 0.057143
Their net profit margin, expressed as a percentage, is 5.7 per cent. For every dollar the cake maker spends on their business, they make 5.7 cents.
That might sound horrifically tiny, but profit margins in this range are not uncommon, especially in food-related industries where costs are high.
Note, this same cake maker could forgo their fancy equipment and the person helping with the icing. They can do everything themselves using stuff they already have at home. By doing that, their costs would go down, and their profit margin would go up; they’d be taking home 14.3 cents for every dollar they make: ($350,000-$300,000) / $350,000 = 0.14286
But would the extra stress of doing everything themselves with inferior equipment be worth the higher profit margin and take-home dollars? Maybe, maybe not. But if you’re a bone-tired cake maker trying to decide whether your venture is worth the dollars it generates, wouldn’t it be nice to have cold, hard numbers to factor into the decision? (Rather than just the emotionality tiredness can trigger?)
8. Break even
Break even is a generally well-understood concept in business finance. It’s the point where total revenue equals total costs, where you are making neither a profit nor a loss.
When our cake maker operates at home by themselves (using non-specialised equipment and no one to help them with the icing), it costs them $300 to make each cake. So they’d only be breaking even if they sell those cakes for $300 each.
Knowing your break even point makes it easy to make good decisions about what you should be selling things for (among other things). In the case of our cake maker, it’s easy for them to realise they should be selling their cakes for $350 rather than $300 and adjust their pricing accordingly.
9. Accounts receivable and payable
Accounts receivable is, in simple terms, money you expect to receive but haven’t received yet. For example, you’ve invoiced a customer/client for work done, but they’ve not yet paid the invoice.
Accounts payable is money you expect to pay. For example, when someone has invoiced your business for something, but you’ve not paid that invoice yet.
Accounts receivable and payable are important when it comes to understanding cash flow.
10. Cash flow
Cash flow is a critical financial element of business that considers:
- Cash in your business account currently.
- Accounts receivable.
- Accounts payable.
- Estimated money coming in over a period of time (for example, predictable income from MRR and expected income based on previous years’ sales).
- Estimated money going out over a period of time (for example, fixed costs and expected costs based on previous years).
Why is it important to understand cash flow and run regular cash flow projections? Because if you don’t, you might find yourself in one of the following un-fun situations:
- Looking at the money that’s in your business account right now and thinking you can spend it when really, it’s needed for accounts payable.
- Noticing cash is running low in your account and freaking out unnecessarily (because there is a good amount of money due to come in from accounts receivable shortly).
- Not knowing whether you have money available to fund growth.
Being across your current and future cash flow ensures you are spending money in an informed way, one that supports the financial viability of your business. It also ensures if growth is your goal, you can pursue that goal in an economically responsible way.
This article originally appeared on Flying Solo, read the original here.
Want more? Get our newsletter delivered straight to your inbox! Follow Kochie’s Business Builders on Facebook, Twitter, Instagram, and LinkedIn.
Now read this:
Expert tips on how to find ‘the one’ in an accountant or bookkeeper
Trending
Weekly business news and insights, delivered to your inbox.