Important Finance Terms Defined
A quick review of some basic financial terminology every entrepreneur should understand.
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In a previous article, I defined the top 10 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 10 more terms you need to know:
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-term contracts; and telecommunications infrastructure. The "cap sheet" typically shows the long-term debt and the equity in the firm. The equity will include preferred stock, common stock and any paid-in capital from outside investors, as well as retained earnings from operations. The various ownership stakes in the company will be delineated, both by shares owned 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 the company. Each year, equipment, buildings, machinery and vehicles lose some of their "newness" to technology advances, as well to everyday wear and tear from usage. Over time, the company is allowed to deduct that "annual loss in value" from its revenues (as if it is a cost), and this lowers the taxable income that must be reported when the company files its annual tax returns. For example, a $100,000 write-off on some equipment is not money that goes out of the company's cash flow, but it does the lower the taxable income by $100,000-and that lowers the amount of tax the company has to pay.
3. Amortization: This term describes how some purchases (or leases) can be posted to the company's books on a periodic basis over time, rather than as a one-time expense. This allows the cost of an item to be deducted slowly over time, 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 determining how much of a given asset's value can be written off each year. It's a schedule with pre-set categories of time for various fixed assets the company acquires. The MACRS table shows what percentage of the asset's value can be deducted as a tax write-off each year, over the useful life of the asset. One advantage is that MACRS assumes all assets have 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 the company. This is the marginal cost, and it should be clearly known by the managers and tracked throughout each month. 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 equipment used). For example, an engineering firm might charge $1,500 for some contract plans, and the firm's cost of producing those is $900 of labor rate plus $100 in printing ($1,000 total). The gross profit is then $1,500 minus $1,000, or $500 on each contract completed.
7. Gross margin: The previously calculated gross profit is then also expressed as a percentage relative to the selling price. This is the gross margin. For example, in the two prior examples, the product produced had a gross margin of 60 percent ($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 the level of sales activity. This burn rate is how much cash the firm goes through in a typical month for things like rent or mortgage for facilities; property taxes; all kinds of insurance (liability, workers compensation and property, for example); 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 and web hosting; research and product development; and bookkeeping/accounting and legal fees. Break-even sales activity is based on how much cash the company burns through every month.
9. Break-even point: This is the point in the annual output where the number of units sold, or number of services provided, produces enough gross profit to cover all the fixed overhead costs of operations. For example, a $100 gross profit per unit of output is first applied to the company's monthly burn rate of $100,000. Once 1,000 units have been sold, the company has reached its break-even point, and every unit sold after that point brings in pure profit to the company, 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 that will 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 to do lower volume, but they make that up with a larger profit margin.
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.