Whether you are running a business or planning to start one, it is imperative to understand the basics of business finance.
There is a rapid rise in the number of small/medium enterprises (SMEs) in India but unfortunately, not every startup survives. To ensure that your business makes the cut, it is your responsibility to take control of SME finance and know your numbers.
Even small businesses need these 3 statements
Those of us who aren’t accountants tend to avoid financial documents if we can. Unfortunately, business owners who ignore their finances aren’t in business for long. To make it easy on you, we’ve narrowed down the three statements you really need.
- Balance sheet.
- Income statement.
- Cash flow statement.
Once we’ve described these three key statements, we’ll suggest some accounting software you can use to create them. We’ll close with common finance mistakes, as well as a list of business finance terms and their definitions below.
1. Balance sheet
A balance sheet is the first financial statement to master. It shows liabilities, equity and assets of the company at any given point in time. It is termed as balance sheet because the liabilities and equity on one side ‘balance’ the assets of the company listed on the other side.
Equity + Liability = Assets
Assets are the items that your business owns and uses to operate. They can be fixed assets (land, machinery), cash in the bank, inventory or accounts receivable.
Liabilities might include loans, accounts payable and equity (funds invested by the owners of the company and others).
Balance sheets also give an idea of the liquidity position of the company. If the company has higher liabilities than assets, then the company is tight on cash.
2. Income statement
An income statement reports the income and expenses of the company for a particular accounting period. This statement includes both operating income (generated from operations of the business) and non-operating income (generated from investments or sale of assets).
On the expense side, it covers:
- Variable costs such as rent, insurance premiums or loan payments
- Fixed costs including salaries, cost of raw materials used in production and utilities
The expense side also reflects the interest that the company must pay on any loans, along with depreciation and tax expenses.
Income statements tell the investors and owners about the net earnings of the company for a given period.
3. Cash flow statement
Cash flow statements help owners know the actual cash position of the company. It provides information on three types of business activities:
By glancing at the cash flow statement, the business owner can identify the reasons for the change in cash over a period.
Popular accounting software to manage SME finance
Accounting software is used to manage financial information and maintain the accounts of the business. Below are a few popular programs that can track all your financial transactions and produce the reports mentioned above:
- Zoho Books
- Saral Accounting Software
When comparing software, look beyond cost to features. Ask yourself: Will more than one person be using this software? Would you like your business finance files stored in the Cloud, thereby giving you access no matter where you are? Read more here on how to choose the app that’s right for you.
Why manage your business finances?
Business finances are managed through proper bookkeeping and maintaining strict controls on the flow of business resources (both money and human resources). This is important to:
Understand the performance of the business
Through close monitoring of the cash flow, you can gauge how much money comes in, when it comes, from whom it comes and how much money is going out when it is going out, and to whom it is going.
Making appropriate business decisions at the right time
You can only make informed decisions if you understand the situation at hand. By knowing what inflows and outflows to expect, you can prepare for any adverse situation in the future.
Comply with statutory obligations
Properly maintaining books helps avoid penalties for non-compliance with tax laws or improper tax filing.
Provide accurate information to stakeholders (if any)
Investors and bank creditors are interested in tracking the financial health of your business. You can only provide them credible information if you maintain your books properly.
Now that we understand the importance of business finance, let’s take a look at some of the mistakes small business owners often make.
Common mistakes in managing business finance
Knowing what to do is important but knowing what not to do is also necessary when we are dealing with business finance. Here are some big NOs:
Mixing of personal and business expenses
Mixing of personal and business expense creates issues like wrong accounting and incorrect tax declaration. Keep your business and personal bank accounts separate.
Not planning for tax obligations
Taxes are a statutory expense—advance planning and keeping taxes in a separate account can reduce the burden at year-end.
Not preparing a budget for the business
Spending more than you earn can be disastrous for any business. Budgeting helps in planning and controlling of expenses.
Learn these few good habits to achieve financial stability.
Key business finance terms
Current Assets: Assets that are expected to be converted to cash within a year
Current Liabilities: Amounts to be paid to creditors within a year
Accounts Receivable: Amounts due to you for the services or goods delivered to customers but yet to be received
Accounts Payable: Amount owed by the business to its suppliers and vendors
Cash Conversion Cycle (CCC): This is a metric that measures the time that the business takes to convert its raw material into cash from sales. It is used to assess the cash management of the company. A well-managed business that receives payments quickly can often negotiate for better terms with its creditors
Net Profit: Net earnings realized by the business after deducting all the expenses from the income
Budgeting: Preparing financial statements like those mentioned above on a quarterly or yearly basis. Budgeting helps in keeping the expenses under control and planning for any adverse events
Variable Costs: Costs directly related to the production of goods like the cost of raw goods, packaging, transportation, etc.
Fixed Costs: Costs that are fixed irrespective of the production and are related to administrative expenses like rent, salaries, stationery, marketing, etc.
Depreciation: A company’s fixed assets like equipment or vehicles have a certain useful life. The decrease in their value is reported as cost in the income statement under the heading of depreciation
Understanding business finance gives you power
Even if you have hired someone to keep your books, there are certain aspects of business finance that you as an owner you must understand. Business finance is not only important for a statutory compliance perspective, but it also enables you to make smart, informed decisions that take it forward.
Knowledge is power — seize yours.