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Basic finance terms that every entrepreneur should fully
understand. They represent the core of understanding howbusiness
development works across all stages in the life of a venture
1. 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-termcontracts; and telecommunications
infrastructure. The "cap sheet" typically shows the long-term debt
and the equity inthe firm. The equity will include preferred stock,
common stock and any paid-in capital from outside investors, as
wellas retained earnings from operations. The various ownership
stakes in the company will be delineated, both by sharesowned and
the relative percentage those represent of the company's total.
2. 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 thecompany. Each
year, equipment, buildings, machinery and vehicles lose some of
their "newness" to technologyadvances, as well to everyday wear and
tear from usage. Over time, the company is allowed to deduct that
"annual lossin value" from its revenues (as if it is a cost), and
this lowers the taxable income that must be reported when
thecompany files its annual tax returns. For example, a $100,000
write-off on some equipment is not money that goes outof the
company's cash flow, but it does the lower the taxable income by
$100,000and that lowers the amount of taxthe company has to
pay.
3. Amortization: This term describes how some purchases (or
leases) can be posted to the company's books on aperiodic basis
over time, rather than as a one-time expense. This allows the cost
of an item to be deducted slowly overtime, rather than hitting the
profit and loss statement all at once.
4. The modified accelerated cost recovery system (MACRS): This
is the generally accepted method for determininghow much of a given
asset's value can be written off each year. It's a schedule with
pre-set categories of time forvarious fixed assets the company
acquires. The MACRS table shows what percentage of the asset's
value can bededucted as a tax write-off each year, over the useful
life of the asset. One advantage is that MACRS assumes all
assetshave 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.
5. Marginal cost: Every additional product produced or service
provided incurs an additional variable cost to thecompany. This is
the marginal cost, and it should be clearly known by the managers
and tracked throughout eachmonth. 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.
6. 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 equipmentused).
For example, an engineering firm might charge $1,500 for some
contract plans, and the firm's cost of producingthose is $900 of
labor rate plus $100 in printing ($1,000 total). The gross profit
is then $1,500 minus $1,000, or $500on each contract completed.
7. Gross margin: The previously calculated gross profit is then
also expressed as a percentage relative to the sellingprice. This
is the gross margin. For example, in the two prior examples, the
product produced had a gross margin of 60percent ($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).
8. Burn rate: Every company has a fixed amount of overhead costs
that has to be paid every month, regardless of thelevel of sales
activity. This burn rate is how much cash the firm goes through in
a typical month for things like rent ormortgage for facilities;
property taxes; all kinds of insurance (liability, workers
compensation and property, forexample); 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
andweb hosting; research and product development; and
bookkeeping/accounting and legal fees. Break-even sales activityis
based on how much cash the company burns through every month.
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9. Break-even point: This is the point in the annual output
where the number of units sold, or number of servicesprovided,
produces enough gross profit to cover all the fixed overhead costs
of operations. For example, a $100 grossprofit per unit of output
is first applied to the company's monthly burn rate of $100,000.
Once 1,000 units have beensold, the company has reached its
break-even point, and every unit sold after that point brings in
pure profit to thecompany, as the fixed overhead has already been
covered.
10. 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 thatwill 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 todo lower volume, but they make that up with a
larger profit margin.
Glossary:
