Learn Some Shit

05 July 2008 | Shit to Know | admin

A quick review of some basic financial terminology every entrepreneur should fully understand. They represent the core of understanding how business development works across all stages in the life of a venture, so it’s important you understand their meaning.

1. Return on investment (ROI): The only way to think about your business is with an ROI perspective. The entrepreneur has committed capital investment into a certain combination of assets, from which the company generates sales. Those sales cover the costs of operations and hopefully produce a profit. That profit, divided by the total funds invested in the company (the assets), equals the ROI to the entrepreneur. Think of it this way: Would you work all those hours and take on all that responsibility if your ROI was only 6 percent annually? The stronger the profit picture compared to the total funds employed in the enterprise, the higher the ROI.

 

2. Internal rate of return (IRR): Every decision enacted by the entrepreneur must be viewed in terms of its internally generated return to the company. Unlike the simple division used to find the ROI, the IRR compares the net expected returns over the useful life of a project being reviewed by management to the funds spent on that decision (or project). All projects must meet a certain IRR in order to be acceptable for investment by the company. If a project cannot meet a minimum IRR, then don’t invest in it.

 

3. Fixed asset base: This is the long-term base of the company’s operation strategy, represented by all the equipment, machinery, vehicles, facilities, IT infrastructure and long-term contracts the firm has invested in to conduct business. From a finance perspective, these assets are the revenue generators. When the entrepreneur decides to invest in a certain fixed asset configuration, that becomes the base from which the company functions week in and week out, doing business and servicing its customers.

 

4. Working capital: Current assets are those short-term funds represented by cash in the bank, funds parked in near-term instruments earning interest, funds tied up in inventory, and all those accounts receivable waiting to be collected. Subtracting the company’s current liabilities from these current assets shows how much working capital (your firm’s truest measure of liquidity) is on hand and its ability to pay for decisions in the short-term. For example, if the firm has $500,000 in current assets and $350,000 in current liabilities, then $150,000 is free and clear as working capital, available for spending on new things as needed by the company.

 

5. Cost of capital: This is the true cost of securing the funds that the business uses to pay for its asset base. Some funds are from debt (less risky to the creditors, so it has a lower cost of capital to the firm), and some funds come from equity (more risky to the investors, so these have a higher cost of capital). The combination of lower-cost debt capital with higher-cost equity capital produces the next item in this list.

 

6. Weighted average (between debt and equity) cost of capital (WACC): This is the firm’s true annual cost to obtain and hold onto the combination of debt and equity that pays for the fixed asset base. Every time the owners contemplate investing in a new project, the IRR for that project must be at least equal to the WACC of the funds used to do that project, otherwise it makes no sense taking on that new project, because its return cannot even cover the cost of the capital employed to make the project happen.

 

7. Risk premium: Entrepreneurs must understand that every decision they consider has an inherent level of risk associated with it. If project A is far riskier than project B, there should be a clear risk premium that could accrue to the firm if project A is enacted. But with that risk premium return, there will also be a risk premium cost to the company for the use of the funds. Business owners always have to decide whether the risk premium of additional potential return is commensurate with the additional risk costs that come with doing that investment project.

 

8. Systematic risk: Some risks facing the company are not unique to that business in that market, but are faced by all firms operating in the broader, general marketplace. These so-called “systematic” risks (such as changes in interest rate levels, the performance and direction of the U.S. economy or the availability of certain types of skilled labor) cannot be avoided.

 

9. Nonsystematic risk: The risks that are entirely unique to your company, products, buyers, promotional programs, billing, pricing, IT system and so on are nonsystematic risks specific to your firm. Although there’s little you can do to avoid or mitigate exposure to systematic risk, it is possible to use various diversification strategies to offset risks that are unique to your business. When working with risk premium, systematic risk and nonsystematic risk, the rule is that the expected return on the business operations will always be directly related to the amount of risk taken on: Lower risk decisions come with lower expected returns, and higher risk decisions come with higher expected returns.

 

10. Option premium: A “call” is an option to buy something at a future date; a “put” is an option to sell something at a future date. On virtually every partnership contract, vendor deal, distributor arrangement, equipment lease or financing, personnel hire and investment decision, there will likely be some kind of option offered to one party by the other. Entrepreneurs must always place a dollar value on any option premium they offer or have offered to them in these various deals. The value of having an option to either buy or sell, agree or disagree, accept certain terms or let them expire, should always be determined prior to signing any deal or contract or term sheet, and that value should always be treated as a tangible benefit when negotiating decisions with parties inside and outside the firm.

 

11. Capitalization: This describes the way the company has funded its fixed assets. These assets include plant, warehousing and other facilities; equipment and machinery; trucks, delivery vans and other vehicles; long-term contracts; and telecommunications infrastructure. The “cap sheet” typically shows the long-term debt and the equity in the firm. The equity will include preferred stock, common stock and any paid-in capital from outside investors, as well as retained earnings from operations. The various ownership stakes in the company will be delineated, both by shares owned and the relative percentage those represent of the company’s total.

 

12. Depreciation: The fixed assets used in company operations have significant tax advantages for the company as well. Depreciation refers to the incremental value of a brand-new asset that is lost each year due to normal use in the company. Each year, equipment, buildings, machinery and vehicles lose some of their “newness” to technology advances, as well to everyday wear and tear from usage. Over time, the company is allowed to deduct that “annual loss in value” from its revenues (as if it is a cost), and this lowers the taxable income that must be reported when the company files its annual tax returns. For example, a $100,000 write-off on some equipment is not money that goes out of the company’s cash flow, but it does the lower the taxable income by $100,000-and that lowers the amount of tax the company has to pay.

 

13. Amortization: This term describes how some purchases (or leases) can be posted to the company’s books on a periodic basis over time, rather than as a one-time expense. This allows the cost of an item to be deducted slowly over time, rather than hitting the profit and loss statement all at once.

 

14. The modified accelerated cost recovery system (MACRS): This is the generally accepted method for determining how much of a given asset’s value can be written off each year. It’s a schedule with pre-set categories of time for various fixed assets the company acquires. The MACRS table shows what percentage of the asset’s value can be deducted as a tax write-off each year, over the useful life of the asset. One advantage is that MACRS assumes all assets have no residual value (or salvage value) after the deductions are completed. This allows the entire cost of the asset to be deducted over time, even though it might still be functioning well in the firm.

 

15. Marginal cost: Every additional product produced or service provided incurs an additional variable cost to the company. This is the marginal cost, and it should be clearly known by the managers and tracked throughout each month. This captures the incremental increase in labor and materials costs for one more unit produced or one more service provided. The product’s selling price should obviously then be above this variable cost of output.

 

16. Gross profit: The company generates a gross profit on every unit of output that sells to a customer. If it’s a product, the gross profit is the difference between the price at which it’s sold, and the per-unit costs of labor and materials to produce that unit. For example, if some electronic device costs the firm $20 in labor and materials, and it sells for $50, the gross profit is $30 on each unit. If the company provides a service, the gross profit is the difference between the billing rate to the customer (client) and the cost of the labor for that service (plus any supporting materials or equipment used). For example, an engineering firm might charge $1,500 for some contract plans, and the firm’s cost of producing those is $900 of labor rate plus $100 in printing ($1,000 total). The gross profit is then $1,500 minus $1,000, or $500 on each contract completed.

 

17. Gross margin: The previously calculated gross profit is then also expressed as a percentage relative to the selling price. This is the gross margin. For example, in the two prior examples, the product produced had a gross margin of 60 percent ($30 gross profit earned on a $50 selling price), and the service contract had a gross margin of 33 percent ($500 profit on a $1,500 contract).

 

18. Burn rate: Every company has a fixed amount of overhead costs that has to be paid every month, regardless of the level of sales activity. This burn rate is how much cash the firm goes through in a typical month for things like rent or mortgage for facilities; property taxes; all kinds of insurance (liability, workers compensation and property, for example); salaries and payroll taxes for employees; the marketing budget; royalty fees or other license agreement fees paid to partners; the printing or copying of mailings; telephones; IT infrastructure, including Internet connections and web hosting; research and product development; and bookkeeping/accounting and legal fees. Break-even sales activity is based on how much cash the company burns through every month.

 

19. Break-even point: This is the point in the annual output where the number of units sold, or number of services provided, produces enough gross profit to cover all the fixed overhead costs of operations. For example, a $100 gross profit per unit of output is first applied to the company’s monthly burn rate of $100,000. Once 1,000 units have been sold, the company has reached its break-even point, and every unit sold after that point brings in pure profit to the company, as the fixed overhead has already been covered.

 

20. Volume: This refers to the quantity of units of output the company sells, or the number of times its services are provided to customers. The company will first determine its break-even volume, and then how many units beyond that will be the profit volume. Total volume is all units sold, or all services provided, for the entire year. Typically, companies that want to do higher volume get there by lowering prices. Premium-priced products and services tend to do lower volume, but they make that up with a larger profit margin.

 

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