The Most Important Financial Concept an Entrepreneur Should Know
The guide will explain how and when to use key financial terms like debt-to-equity ratio, and EBITDA. It also provides links to other comprehensive guides that can help further your understanding.
If you feel that after reading the guide you have forgotten all the techniques of business valuation, it is easy. You can bookmark or email this page so you can quickly refer to the information during meetings. The page can also be emailed. Sometimes, working smarter can make you look like a financial genius.
1. Return on Investment (ROI).
Return on Investment (ROI) is also called ROI. It is used as a way to calculate the profit of an investment. You can use ROI in two different ways.
What is ROI?
ROI is expressed in three ways.
- A ratio
- Percentage
- ROI expressed in 5x and 10x is most common when greater than 100 percent. ROI is usually expressed by 5x or 10.
ROI Formulas
There are two methods to calculate return on investment. They both produce the same result. The choice is yours.
- ROI = (Net profit/Cost investment) x 100
- ROI = ([Present value – Cost Of Investment]/Cost Of Investment) x100
How Small Businesses Can Use ROI
You can use ROI to evaluate whether the time, money, and resources you invested were worthwhile.
Use ROI (Return on Investment) to estimate or calculate the value of expenditure in:
- Equipment
- Personnel (additional staff)
- Marketing campaigns
- How to Launch a New Product
- Open a brick-and-mortar store
- Investing in bigger purchase orders/inventory
2. Return on Advertising Spending (ROAS)
ROAS, on the other hand, measures the specific profitability of an advertising budget.
Calculating ROAS
ROAS = Gross Revenue from Advertising Costs – Ad Spend
How do you define a ROAS (Return on Assets)?
A ROAS of over 400% is considered good. The ROAS that is required by each company is unique. Some businesses need a high ROAS to remain profitable. Ecommerce companies can achieve a much lower ROAS because they don’t incur additional costs.
3. Working Capital
The liquid capital is cash flow. A company’s working capital can be determined by dividing the current assets and liabilities OR by subtracting the current liabilities.
Work Capital Formulas
- Net working capital = Current assets – Current liabilities
- Working Capital Ratio = Current Assets/ Current Liabilities
Include accounts receivables in your business’s bank account if they are due to be converted within the next 12 months.
How should you calculate working capital? You can include salary, tax, and payables such as outstanding credit card or vendor balances.
Why Working Capital Matters for Entrepreneurs
Working capital is a concept that every entrepreneur should understand. Working capital gives you an idea about the health of your business in the short term.
Why extra Working Capital is needed or desired
- Suppliers offer bulk discounts
- Paying a lot of bills
- Cover employee wages and other expenses in times of recession
- You can buy another business
4. Profit Margins
Profit margins can be used as a measure of a company’s success. Profit margins are a key metric for determining if a business is profitable. The greater your profit margin, the more flexible you will be. On the contrary, seeking profit for the sake of profit can result in a reduction of quality (which may cause many challenges ). ).
Calculating profit margins in different ways
Profit margins come in three different types. They each have their benefits and advantages. By deciding how you intend to use them, you can decide which one you’ll use. Learn how to apply the various profit margins to a wide range of business situations.
- Gross profit margin. The gross profit margin measures the profitability of your business compared with its costs.
- Gross Profit Margin: Use your gross profit to determine pricing and production strategies.
- The operating margin gives you a good idea about the daily profitability of your company. It excludes taxes and interest.
How to Calculate Your Profit Margin
The formula for each of the three different types of margins of profit is unique.
- Net Profit Margin = Net Profit / Net Revenue x 100
- Gross Profit Margin = Gross Profit / Total Revenue
- Operating Profit Margin = (Operating Income / Net Sales) x 100
Calculating Profit Margins Effectively
Monitor your gross margin, net profit, and operating margin to avoid any unpleasant surprises.
5. Cost of Goods Sold
The cost of goods sold is COGS. The cost of goods sold includes inventory costs, labor costs, and packaging costs.
What does the Cost of Goods Sold include?
The cost of goods, or COGS (cost of sales), is calculated based on your company’s products and costs. Below are some examples of what you might include in your COGS calculation.
- Shipping
- Direct Labor
- Raw Materials
- Distribution costs
- Resellable products
- Items needed to finish a product
- What is needed to market your product?
Calculate the cost of goods sold.
Calculate the cost of goods sold by adding up your beginning inventory + purchases and subtracting it from the ending stock
The amount of stock you own at the end of the financial year is called the “ending inventory”.
6. Earnings
Total revenue is how much money a business earns before accounting expenses.
Why Revenue Is Important
Revenue is a measure of the ability to earn money for a business. However, they may still be able to produce revenue even though they aren’t profitable. If you don’t have any revenue, it is impossible to make money.
7. Business Valuation
The value of your small business can help you stay committed to it during difficult times.
Business Valuation Methods
There are several ways to determine the value of a business. This topic will be limited to the five most popular methods of business valuation. You’ll likely use at least one of them to value your company.
- Historical earnings value: This is a measure of the worth of a company based on its revenue (gross profits), cash flow, and ability to repay debt.
- It is used for determining the value of a business. This calculates the value of an identical business if it were sold.
- Asset Value Asset value is the totaling of market value of the tangible and intangible assets of a business to calculate the company’s worth.
- Future maintainable earnings value: The method uses the future profit to calculate the current business valuation. To estimate the future income, revenue, and expenses, you can look at the data for the last three years.
- Discounted Cash Flow: This method is used when future profits are expected to be unstable.
8. Accounting Year
The fiscal year differs from the standard calendar year.
9. Depreciation
The depreciation of an asset is its value reduction over time. The loss in value occurs most commonly due to normal wear and tear.
Why Companies Use Depreciation
Most commonly, depreciation is applied to expensive assets such as machinery and equipment. Some of these purchases, especially if they’re manufacturing-related, can get expensive. Depreciation is often used by companies to spread the cost over time.
Types of depreciation
- Straight Line Depreciation – This is the easiest way to calculate depreciation. The method allows businesses to depreciate assets at the same rate yearly until they reach the salvage value.
- The declining balance method is calculated using a straight-line percentage. This method accounts for an asset losing more value later in life.
- Double Declining (DDB), Balance: DDB is simply the straight-line depreciation divided by 2.
10. Amortization
Amortization can also be a way of accounting, which divides the amount of debt into smaller amounts over time.
Earnings Before Interest, Taxes, and Depreciation
EBITDA, or earnings before tax, depreciation, and amortization is one of the most popular metrics used by startups to measure their profit. EBITDA stands for Earnings Before Tax, Depreciation, and Amortization.
EBITDA can be important to small businesses, particularly if the company has venture capital backing or is looking to attract investors. It’s important to understand what EBITDA is and how it functions.
Calculating EBITDA
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization
If you’d like to know how to do this, consult our EBITDA Guide. If you want to learn how to calculate EBITDA, please consult our EBITDA Guide ).
What EBITDA tells us about a business
EBITDA measures what the company is capable of, and not how it currently operates. To achieve their growth goals, scaling startups often borrow large amounts of money. The debt they incur can cause the business to be unprofitable in the short term. By removing the debt, we can determine the business’ profitability after repayment.
EBITDA Calculations & Terms You Should Know
- EBITDA margin – EBITDA is a measure of profitability for a business. EBITDA/Revenue
- The Adjusted EBITDA is a measure that accounts for the anomalies unique to each business. This makes it easy to compare a business’s performance with that of other companies in the same industry.
- EBIT (EBIT = Gross income + interest + taxes)
- EBITDA to interest coverage ratio (EBITDA/Total Payments of Interest). This ratio is used to determine whether an organization has enough profit to be able to pay off its debt.
- EBITDA Multiplier: EBITDA multiplier is used to measure the return on investment of an organization. EBITDA multiple = Enterprise Value/EBITDA
12. Customer Acquisition Costs (CAC)
Customer Acquisition Costs (CAC) are the costs incurred by a business to gain a new customer. The CAC includes all the equipment and property you need to acquire a customer.
Unit economics is a ratio that is used to explain the relationship between CAC and lifetime value.
Customer acquisition costs (CACs): What are they?
- Direct advertising costs
- The cost of creativity
- Production Costs
- Inventory Costs
- Compensation for the marketing team
- Sales team salary/pay
Simple Formula for Customer Acquisition Cost
CAC is (Costs for Sales + Marketing costs)/Number of customers acquired
13. Customer Lifetime Value
The customer lifetime value is the measure of the customer’s value over their lifetime relationship with a firm. It is important to increase your LTV because it can be expensive for a business to acquire new customers.
Calculating Customer Lifetime Value
Customer Lifetime Value = Average Purchases x Average Order Total in a Year
Why Customer Lifetime Value Matters for Entrepreneurs
LTV can be a good way for companies to gauge the relationship value over time.
You can use the customer lifetime value to calculate the return on your CAC. We will discuss this in greater detail under the unit economics section.
14. Unit Economics
A unit’s value is determined by its acquisition costs.
The formula for Unit Profitability
Unit profitability = Customer acquisition cost – Customer lifetime value
Why unit economics is important for entrepreneurs
Unit economics can give you a good idea about the efficiency of your marketing efforts. By analyzing unit economics, you will be able to identify strengths and weaknesses. Both CAC and LTV provide useful information, but the relationship between them will allow you to gain more valuable insights.
Debt-to-Equity Ratio
A business’s debt-to-equity ratio is calculated by comparing the company’s liabilities to its shareholder equity. This ratio indicates how much an organization finances its operations through debt, as opposed to its funds.
How to Calculate Debt-Equity Ratio
Dividends as Equity = (Short Term Debt + Long Term Debt + Other Fixed Payments plus Shareholders’ equity)
The Debt-Equity Ratio and What Entrepreneurs Should Know
Debt-to-equity ratios are only important if your company has external debt or investors. D/E is a measure of risk that a business faces as a result of its funding source.
Business Credit
Credit scores are used by lenders to determine a business’s creditworthiness.
Factors that influence your credit score for business
By Experian, these factors are most likely to affect your credit rating.
- For how long has your business been operating?
- Lines of Credit for the past 9 months
- Have you opened new credit lines?
- Collections of Liens and Levys for the Last 7 Years
- Payment history
Establishing business credit
To build credit, you can use credit lines provided by suppliers, vendors, or retailers.
