Like any profession, accounting has what seems to be impenetrable jargon to outsiders. But, also like most professions, the jargon is just shorthand for the most-used and usually most important terms when accountants talk about the businesses they are either managing or evaluating.
Here’s your mini-CFO guide to the 15 most important – and also useful – terms that small business owners need to understand so they can have meaningful conversations with their accountant and manage their business better.
MARGIN AND PRICES
1. COGS: cost of goods sold
You can’t run a profitable business unless you make a margin between what it costs to source the product and what you receive from selling your goods and services to customers.
A businesses cost of goods sold includes the cost of purchasing the good from the supplier as well as any additional costs that accrues to the from its supplier plus any additional costs that are incurred getting the product into inventory and ready for sale to customers.
Cost of goods sold does not include selling and administration expenses, administrative expenses or financing expenses. All of these additional factors impact overall business profitability but they are included later on your income statement.
2. Gross Profit Margin
Now that you know how much your cost of goods were, and when you have a solid read on how much revenue your sales generated, then you are ready to calculate your gross profit margin.
This is just the first step in working out overall profitability of your business as it is simply the difference between the selling price of a good or service and the revenue received.
Your margin is then calculated as a gross margin percentage which shows the proportion of profit for each sales dollar. The higher, the better.
3. Operating Profit Margin
The gross profit margin doesn’t tell you what it costs to operate your business. It doesn’t take into account the “other” fixed and variable costs of generating sales revenue.
Operating expenses are those incurred as a result of normal business operations, (wages, R&D and so on) and together with the cost of goods sold these are subtracted from sales revenue to give an “operating income” figure.
Operating Income (profit) is then divided by sales revenue to give an operating margin. Once again the higher the margin the better.
Earnings before interest and taxes is effectively your operating profit.
The calculation of EBIT is:
EBIT = Revenue-COGS-Operating Expenses
For smaller business EBIT is less relevant than for larger firms with more complex capital structures, given that EBIT seeks to discount the costs associated with interest and taxes.
But your accountant may refer to EBIT so just remember it’s just your operating profit. That’s easier to remember and also in many ways more relevant to small businesses because it essentially captures the lifeblood of any business – cashflow – and tells you what is left each week, month and year to ensure your business remains healthy.
Now we’re getting a little more complicated but with EBITDA (Earnings before interest, taxes, depreciation and amortisation) we are also getting closer to what a business actually makes each year for tax purposes.
This is different to cashflow – which in many ways is more important to small business (more on this below) but EBITDA will determine how much you pay or get back from the tax man when you put in your annual return.
EBITDA is calculated as follows:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization)
Net Profit after Tax is your bottom line.
It’s what your accountant will tell you you have made after all your revenues and expenses have been added and subtracted – after your add-backs have been tallied, and after what you owe the tax man is deducted.
It’s your bottom line and the (hopefully) positive number at the end becomes eligible for a dividend payment to shareholders or it can stay in the business as retained earnings.
BUSINESS HEALTH AND HYGEINE CHECK
7. Current ratio
Ratio analysis might seem arcane but calculating some of them will help you estimate, evaluate and hygiene check your businesses health in real time.
The current ratio is the simplest of all business ratios and simply lets you know that your business has enough current (liquid) assets to satisfy current debts (current being the accounting term for within 12 months).
It can include inventory, which will be expected to be sold, and the calculation is:
Current Ratio = Total Current Assets / Total Current Liabilities
This is one ASIC is interested in, the one your accountant will get you to sign off on, and the one that has caught company directors of large corporations in the past.
8. Quick ratio
Where the current ratio can give a feel for the likely ability of your business to repay debts and remain solvent, the Quick Ratio is in many ways the real version of your ability to survive a business shock.
Some call it the “acid test” as it is more conservative than the current ratio as it excludes inventory – which has an uncertain sales pipeline and price – from the cash generation projection.
Calculation of the quick ratio is as follows:
Quick Ratio = [Cash on hand (including marketable securities) + Receivables] / Total Current Liabilities
The larger the number the better – it means you have more cash available. But as with everything in accounting, that is only up to a point. But that’s a discussion for you and your accountant.
9. Debt to equity
This one is straightforward, telling you the leverage you are employing in your business.
The calculation of this leverage ratio of debt to equity is simply the level of debt held divided by shareholders’ equity. Theoretically the lower the better but once again the balance depends on the business, its goals and the market it operates in.
10. Inventory turnover
This one is closely related to sales and solvency. When a business puts something in inventory it is with the expectation that it will be sold.
So if the business is not selling inventory and thus not generating revenue, then cash flow problems can occur. By establishing how many times your inventory turns over per annum you can get a feel of the cashflow generated by sales.
Inventory Turnover = COGS/Average Inventory
Average inventory is calculated as:
Inventory @ Start + Inventory @ End / 2
11. Accounts Receivable turnover
There are essentially two important rules in staying in business.
Do the business, that is generate sales, and then collect the cash.
Without the first rule there is no cash generated but without collecting cash, your business is going to go broke.
The accounts receivable turnover ratio simply tells you how often you can turn over your debtors ledger during a year. It can help with cash flow planning and knowing if it is increasing can be an early warning that clients are under pressure.
The formula is:
Accounts Receivable Turnover ratio = Net Credit Sales/Average Accounts receivable.
Now that we have the business running smoothly, we know our profitability, our health, and our cashflows we can think about growing.
Sometimes you’ll see CAGR written down (or you might hear someone say “Kay Gar”. Shiver).
These are terms often associated with investment returns but compound annual growth rate is an important one to measure the growth of your business and in a world where an idea can generate an app or a business that grows and can be sold quickly CAGR will help get the best price.
And for those who want to keep and run their business, well you need to know how fast you are growing so you don’t run into cashflow problems from getting too big to fast.
Year on Year is simply a measure on where you are now in terms of sales growth compared to where you were a year ago.
This growth rate for sales, or revenue, or staff, or any other relevant metric can be generated by simply taking the latest data, subtracting it from the start date 12 months ago and then dividing it by the start data.
YOY Growth rate = (Sales Now – Sales 12 months ago)/Sales 12 months ago
Month on Month sales is the same as above except over a shorter time frame.
It may seem simplistic to include YoY growth and MoM growth rates in a list that also includes many of the ratios and analysis above but the truth of the practical application of business management is that many small business owners are in their businesses every day and every week.
The calculation of something as simple as the MoM, QoQ or YoY growth rate of sales, revenues, operating costs, or profit is a way to reflect objectively on how your business is going.
Accounting acronyms might seem arcane but they go to the heart of building a long term sustainable and profitable business.