There are a few basic finance terms that 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.
Here's a quick review of the terms you need to know:
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.
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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.
David Newton is a professor of entrepreneurial finance and
head of the entrepreneurship program, which he founded in 1990, at
Westmont College in Santa Barbara, California. The author of four
books on both entrepreneurship and finance investments, David was
formerly a contributing editor on growth capital for Industry
Week Growing Companies magazine and has contributed to such
publications as Entrepreneur, Your Money,
Success, Red Herring, Business Week, Inc.
and Solutions. He's also consulted to nearly 100
emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are
those of the author, not of Entrepreneur.com. All answers are
intended to be general in nature, without regard to specific
geographical areas or circumstances, and should only be relied upon
after consulting an appropriate expert, such as an attorney or
accountant.