Top 10 Finance Terms
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.
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.