When I was around eight years old, my friends and I used to set up lemonade stands all all summer to try and earn some spending money. We would make up some lemonade, take some paper cups from the cupboard and set up a table on the corner of our neighborhood. On a good day we would make $10 or so and split it between two or three of us.
Since we would just take the supplies from our homes, we never thought about the costs involved with running a lemonade stand. As far as we were concerned, every penny we earned from selling a dixie cup full of lemonade was money in our pockets. Then one day we didn’t have any lemonade to make and asked my Mom to run to the store for us. She agreed to go, probably in an effort to get us out of the house for the day, and brought us home everything we needed. We mixed up the lemonade and off we went for a day of entrepreneurial fun.
When I got back later that day after taking my $3 share of the income, Mom informed me that I owed her $4 for the lemonade mix she bought for us. uh, what? Suddenly my $3 profit was a $1 loss. I don’t remember if she actually took my money or not, but I do know she had taught me valuable lesson- making money usually has costs involved. Even in an operation as small as a lemonade stand, you still have to buy the lemonade mix and the cups. I had never even considered concepts like costs of goods sold and net income versus simple gross revenue.
Know Your Numbers
Most entrepreneurs know there are costs involved in running their business, but I find that many of them are a little ignorant on the financial terms involved in their business. A lot of small business owners don’t even want to know these financial terms, they tell me it is what they are paying me for. While I certainly don’t mind being paid to help them out, I strongly believe every business owner should know their own financials inside and out.
Here are six financial terms, in comparison format, every entrepreneur should know:
1. Gross Revenue vs. Net Income
Like my lemonade business over 20 years ago, many entrepreneurs consider their gross income – what they actually receive from customers and clients – their profit. Unfortunately, we have to account for costs.
Your gross revenue is simply the amount of money you are paid by clients and customers. Your net income is the money that is left after paying your expenses. Obviously net income tells a much more accurate story than gross revenue.
2. Variable Costs vs. Fixed Costs
Every year, I have multiple small business owners bring me two numbers to do their taxes. Their total income and their total expenses. When I ask them if they have these numbers broken down further, they seem shocked that I would expect that. When it comes to a business, not all costs are the same. Perhaps the most important way to distinguish them is between variable costs and fixed costs.
Variable costs will go up or down based on how much product or service you sell. These costs are directly tied to earning revenue. Because of this, they are called cost of goods sold, or in the case of a service company, cost of revenue. These will include items like sales commissions, supplies and raw materials, and independent contractors. If the expense can be tied to a specific sale, it is likely a variable cost.
Fixed costs, on the other hand, will remain the same no matter how much you product or service you sell. These are called operational costs, and they will include things like rent, salaries, insurance, advertising and marketing and any other business cost that is not tied to an individual sale.
Usually variable costs are easier to cut than fixed costs. Fixed costs tend to be locked into long term contracts, such as rent contracts and employment contracts, where as you can attempt to adjust variable costs at any time.
3. Equity vs. Debt
Unless they have the cash sitting handy nearby, most entrepreneurs are forced to use other peoples money to fund their business at some point. There are two choices to do this, you can take on debt, or your can give out equity.
Debt is pretty self explanatory. You need money to buy a large piece of equipment, so you take a loan from the bank to pay for it. Debt generally comes at a cost of interest owed to the lender.
Equity is ownership in your company. Once again you need money to fund your company, but instead of taking on debt, you decide to sell equity in your company to acquire the cash you need. Unlike debt, there is no interest expense involved with equity, however you are giving up a piece of your business that could be worth much more down the road.
For the most part, debt is more dangerous than equity because of the cost of interest. But giving up too much equity can leave you with very little say in your own business. As Steve Jobs found out the hard way, even the founder of the company can be fired once he no longer owns most it.
No One Cares More About Your Company Than You
While there are plenty of accountants and CPA’s out there willing to take the numbers work out of your hands, it’s extremely important for you to know and understand the key financial terms in your business.
When it comes down to it, no one cares more about your business than you. Make sure you are protecting it by knowing the key numbers involved.