Entrepreneurship
Glossary
SECTION 7
GENERAL FINANCE TERMS
As a founder, you will need to understand the basics of finance - knowing your business numbers and reporting your business numbers to (potential) investors, understanding the financial situation your company is in, and when you are going to run out of money.
In some businesses, such as services or software, you may not incur any costs of sales, in which case your gross profit i.e. sales revenues minus the cost of sales may be close to 100%. But with products, you may well find that the gross profits drop to say 30% to 40% because Investors like to understand your gross profits as this is how you will finance the running (operating costs or overheads) and make profits from efficiencies – thereby being able to return a net profit. The question that will come up is about volume sales – in the context of gross profits. A high percent gross profit with large volumes is very attractive as everyone benefits; while a low gross margin with low volumes would make the enterprise hard to sustain over time, especially if it is in a
competitive market.
Whether you are talking with investors, family and friends or your team you will need to be able to explain your numbers – in the end being in business means you have to understand and explain how your sales, costs, assets, liabilities and cashflows through your enterprise.
(Earnings before Interest, Tax, Depreciation and Amortisation)
COSTS
01
You need to understand the costs associated with starting the business. You can then start to plan out when these costs will likely to be incurred and project cash flow. This allows you to answer the question: how will you spend the investment we make and when do you need the funds?
You will have:
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Fixed costs - costs that you incur whether or not you make the product and sell anything. These can include eg offices, marketing, rents, light and heat; communications; professional services.
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Cost of sales or cost of goods sold - these are variable costs: the costs that you incur to make a product that you have to sell e.g. materials and labour.
These costs increase when you make and sell more. Some companies may not incur costs of sales - e.g. services companies who are not making a product.
REVENUE / SALES REVENUE / INCOME
02
All revenue or income from the sales of your product or service. This is the selling price per unit x
the number of units.
Until you actually are selling products or services, you will have to use a rationale to predicting your sales and profits
GROSS PROFIT
03
Gross profit = Sales revenues minus the cost of sales
Until you actually are selling products or services, you will have to use a rationale to predicting your sales and profits
EBITDA
04
(Earnings before Interest, Tax, Depreciation and Amortisation)
EBITDA = gross profit minus fixed costs
AMORTISATION
06
The process of paying off assets over time.
CASH FLOW FORECAST
08
A forecasting tool to help you understand:
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What cash will flow into your accounts and when
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When you will be obliged to make payments and how much those payments will be
This is a hugely important document that needs to be updated in almost real time as cash is king! If you run out of cash your business is over.
CASH IS KING
09
"Cash is king" means that cash in the bank is what founders of start-ups need prioritise. The should be on trying to minimise the monthly burn rate or costs a company has/month. If you run out of cash your business is over.
A company with assets other than cash (e.g real estate, equipment etc) can still fail unless those assets can be converted quickly to cash if you reach the end of your runway with no further income. It is possible to be technically bankrupt despite a positive net worth.
BREAK-EVEN
10
The break-even point occurs when a business achieves a volume of sales to cover its total costs. In the case of break-even there are neither profits nor losses.
E.g. a product sells for £20 and has variable costs per unit of £16. Each unit sale therefore makes a contribution of £4 towards the fixed costs of the business. If the business had fixed costs of £32,000, then it would need to sell 8,000 units (£4 x 8,000 = £32,000 contribution) in order to break even.
Once the business has sold 8,000 units, then the additional sales contribute to the profit of the business
“When will the business start making money?” is the question most people ask when launching their own company and it’s a key one for most start-ups. Conducting break even analysis lets you model different ‘what if?’ scenarios, such as how many sales would you need to make if you lowered or raised your unit price.
BURN RATE
11
The burn rate is used by startup companies and investors to track the amount of monthly cash that a company spends before it starts generating its own income. If your burn rate is £50K/month, that means that you spend £50K/month. If you have £500,000 in the bank and you’re burn rate is £50K/month, you’ll run out of money after 10 months.
A company's burn rate is used as a measuring stick for its runway, the amount of time the company has before it runs out of money.
Burn rate is used to describe how fast a company is spending its cash reserves to fund overheads.
82% of startups fail because of cash flow problems so cash flow is often taken for granted by young businesses. Understanding burn rate is key to both recognizing areas for improvement within your company and planning for the future.
You should ideally target having 18 -21 months of runway at any given time. That way, you can take the hit of an unexpected expense, a market downturn, or a complication with your product without feeling the heat of a sudden burn rate increase.
"SKIN IN THE GAME"
12
"Skin in the game" is a colloquial phrase describing the situation when business owners, managers etc have heavily invested financially in the business they own or work for.
TRACTION
13
Traction refers to progress and growth of a start-up. A business is said to have gained traction when it has achieved an amount of success (often quite small) which will give it the momentum to accelerate its growth. For example, they may have early revenue from first paying customers or number of registered users or partnerships which are indications of validation of the product/service etc.
OUTSOURCING
14
The practice of using third party companies to deliver services and functions, including in some cases product creation, which would otherwise be performed in- house. It is usually undertaken as a cost saving measure, or to access expertise which is not available within your company.