As an entrepreneur, you’re asked to know a little about a lot. That includes finance. As you run a small business, you’ll run into all kinds of financial lingo. We’ve put together a dictionary of the most important financial terms and concepts that every small business needs to know. This guide will get you up to speed, defining terms like debt-to-equity ratio and EBITDA, and explain how and when you’ll need to use them. We’ll also link out to more robust guides if you want to deepen your understanding.
And what if you feel like you’re going to forget the business valuation methods as soon as you finish reading this guide? Easy. You can bookmark this page or email it to yourself so you can quickly reference it on the fly during meetings. Sometimes looking like a financial genius is all about working smarter, not harder.
Table of Contents
1. Return on Investment (ROI)
Return on investment (ROI) is a calculation used to determine whether or not an investment is profitable. ROI is used in 2 ways: to determine the estimated return of a future or current investment and as an analysis tool after the fact to determine how profitable the investment was.
Ways ROI Can Be Expressed
ROI can be expressed in 3 different ways:
- As a ratio
- As a percentage
- As a multiple (i.e. 5x or 10x, most commonly used when ROI is greater than 100%)
There are 2 ways to calculate ROI. Both will give you the same result. It’s just a matter of preference in calculation method:
- ROI = (Net Profit/Cost of Investment) x 100
- ROI = ([Present Value – Cost of Investment]/Cost of Investment) x 100
When You’ll Use ROI as a Small Business Owner
As a small business owner, ROI is a primary metric that you’ll use to evaluate the value of an initiative. You’ll use ROI as an estimate before undertaking an initiative or incurring an expense to estimate its potential value to the business. You’ll also use ROI after the fact to determine whether or not your investment of time, resources, and/or capital was worth it (and if it was, how worth it).
You can use ROI to estimate or calculate the value of investing in:
- Personnel (additional employees)
- Marketing campaigns
- Launching a new product
- Opening a brick and mortar store
- Investing in larger purchase orders/inventory
2. Return on Advertising Spend (ROAS)
Return on advertising spending (ROAS) is a financial ratio that calculates the profitability of your advertising spending. ROAS is like a more focused version of ROI and it’s calculated similarly. The main difference is that ROAS specifically measures the profitability of ad spending.
How to Calculate ROAS
ROAS = Gross Revenue from Ad Spend – Advertising Cost
What is a Good ROAS?
A ROAS of 4x (aka 4:1 or 400%) is considered the typical benchmark for online advertising spending. That said, what makes a good ROAS varies from business to business. Some businesses will need a much higher ROAS to remain profitable, while other businesses can handle a lower ROAS while maintaining profitability. Ecommerce businesses, for example, can typically carry a lower ROAS because they don’t have the additional costs associated with brick and mortar retailers.
3. Working Capital
Working capital, or cash flow, refers to the liquid capital a business has. Working capital can be calculated in 2 ways, either as the net working capital ratio (calculated by dividing your current assets by your current liabilities) or net working capital (calculated by subtracting your current liabilities from your current assets.
Working Capital Formulas
- Net Working Capital = Current Assets – Current Liabilities
- Working Capital Ratio = Current Assets / Current Liabilities
The goal of calculating working capital is to help you assess if you have enough cash on hand to cover a given expenditure. As a result, you want to limit the assets that you include in your working capital to your short-term assets like the cash you have on hand (i.e. in your business bank account) and accounts receivable that you expect to convert within the next 12 months.
What should you include in the current liabilities for your working capital calculation? You’ll want to include salary, taxes, and accounts payable (outstanding balances owed to vendors, credit card balances, etc).
Why Working Capital Matters for Entrepreneurs
Working capital is one of the most important financial metrics that you’ll need to know as an entrepreneur because it gives you a sense of the short-term financial health of your business. How much working capital, or cash flow, your business has may fluctuate throughout the year. Month-by-month financial forecasting and recording can help you narrow down the exact cadence of your working capital growth and restrictions. Once you have a sense of how your cash flow will fluctuate, you can plan for moments when you may need additional working capital.
Reasons You Might Need or Want Extra Working Capital
- To take advantage of bulk discounts from suppliers
- To meet an influx of bills from vendors
- To cover tax, employee salaries, and other costs during downturns
- To acquire another business
4. Profit Margins
Profit margin is one of the commonly used metrics for determining a small business’s profitability. The higher your business’s profit margin, the more flexibility you’ll have, but on the flip side, the pursuit of profit for profit’s sake can reduce the quality of your products/services (which can create a series of other challenges). For small business owners, the goal is to find the ideal balance between profit margin, quality, and other company values (like sustainability, community investment, etc).
Types of Profit Margin Calculations
There are 3 types of profit margins. All of them measure profitability in a different way and have their own benefits. The best way to know which one you’ll want to use is to determine how you want to use it. We’ll walk you through the business cases where each profit margin type is most useful.
- Net profit margin: Your net profit margin provides a sense of the company’s profitability in relation to your expenses
- Gross profit margin: Your gross profit margin can be used to evaluate pricing strategies, production processes, and manufacturing efforts.
- Operating profit margin: Your operating profit margin will give you a sense of how profitable your business is after materials and wages. Your operating profit margin gives you a sense of how profitable your business is day-to-day. Crucially, it doesn’t include expenses like taxes and interest (In this way, it’s similar to EBITDA, which we’ll cover later).
How to Calculate Your Profit Margins
Each of the 3 profit margin types has its own formula.
- Net Profit Margin = (Net Profit / Net Revenue) x 100
- Gross Profit Margin = Gross Profit / Total Revenue
- Operating Profit Margin = (Operating Income / Net Sales) x 100
How to Use Profit Margin Calculations Effectively
Your profit margins can act as your North Star to guide other business decisions. When you’re regularly checking on your profit margins, it will predict other important financial metrics, like your working capital. To get the most out of your profit margin metrics, you want to regularly check up on them. Various factors throughout the supply chain can affect your profit margin, as we’ve seen with supply chain strain in 2021. By regularly checking in on your net profit margin, gross profit margin, and operating profit margin, you can avoid negative surprises in your end-of-year reporting.
5. Cost of Goods Sold (COGS)
Cost of goods sold, or COGS, refers to the specific costs related to the direct sale of products—including inventory, packaging, labor production costs, and raw materials. Your COGS is a foundational expense calculation that can be used to calculate other important business metrics. For example, your COGS can be used to calculate your gross profit (by subtracting COGS from sales revenue).
What’s Included in Cost of Goods Sold (COGS)
Your cost of goods (COGS) calculation will be dependent on your business’s specific products and expense types. Here are some common examples of what might be included in your COGS:
- Direct labor
- Raw materials
- Distribution costs
- Finished products to resale
- Items needed to finish a product
- Things needed to sell a product
How to Calculate Cost of Goods Sold (COGS)
Cost of Goods Sold = (Beginning Inventory + Purchases) – Ending Inventory
Your “beginning inventory” refers to your inventory’s value at the start of an accounting year. “Purchases” includes any spending related to buying or making your goods during the same period. Your “ending inventory” refers to the value of your inventory at the end of an accounting year.
Read more: Tips for Cracking the Cost of Goods Sold Formula.
Revenue, or gross sales, is the total amount of money generated by a business. Revenue is often referred to as the “top line”—a name it’s earned because of its placement at the top of the profit and loss (P&L) sheet. Revenue is how much money your business has earned without accounting for any expenses.
Why Revenue Matters
Revenue demonstrates a business’s ability to generate sales. While businesses ultimately want to be profitable—and businesses can often generate a lot of revenue without being profitable—you can’t turn a profit without revenue to begin with. Revenue indicates demand within the market.
7. Valuation (Business Value)
Valuation at its most basic level is the estimate of what something is worth. For most small business owners, valuation will refer to the value of their company based on a specific formula. Knowing your business’s valuation is helpful in a few different ways. If you’re seeking investors, the investment that they make will be based on your company’s valuation. If you’re selling your business, how much you can ask is largely based on your company’s valuation (although in those cases, valuation can get much more granular). Knowing your company’s value can also help keep you motivated. Starting a small business is hard. Running a small business can be just as tough. Being able to point to a specific number and say, “I built a company that’s worth this much” can help you stick with it through tough times.
Business Valuation Methods
There are several ways that a business’s worth can be measured. Because this topic can get a little complicated, we’re going to limit it to 5 of the most popular business valuation methods. If you’re trying to determine your business’s value, it’s likely you’ll use one of these methods.
- Historical Earnings Valuation: Historical earnings valuation determines a company’s value based on its revenue (gross income), ability to repay debt and cash flow.
- Relative Valuation: Relative valuation determines a business’s valuation by calculating how much a similar business would be worth if it were sold.
- Asset Valuation: Asset valuation totals the worth of a business’s tangible and intangible assets, using market value, to determine a company’s worth.
- Future Maintainable Earnings Valuation: This valuation method uses future profitability to determine a business’s value today. You can calculate the future maintainable earnings valuation by looking at the business’s past 3 years of revenue, profits, and expenses to determine what a reasonable estimate of future profits would be.
- Discount Cash Flow Valuation: The discount cash flow method is used when profits are not expected to be stable in the future.
8. Fiscal/Accounting Year
A fiscal year is an accounting year that does not match the calendar year. A fiscal, or accounting, year refers to either a set 12-month or 52/53 week period. Fiscal years are referred to by the year in which they end, rather than the year in which they begin. The US government, for example, has set fiscal year dates that businesses then follow for tax purposes.
Depreciation refers to the loss in value of an asset over a specific period of time, most commonly due to wear and tear. Depreciation allows small businesses to assign a specific value to the use of an asset, relative to how much revenue is generated. Companies can use depreciation for tax and accounting purposes. It can also give you valuable information about the life expectancy of some of your most valuable assets.
Why Businesses Use Depreciation
Depreciation most commonly is applied to expensive assets like machinery and equipment. Some of these purchases, especially if they’re manufacturing-related, can get really expensive. As a result, companies will often use depreciation to spread out the cost of the equipment over time, rather than realizing the asset’s entire cost in a single year.
Types of Depreciation
- Straight-Line: The straight-line depreciation method is the most basic way to record depreciation. Using this method, a business records an equal amount of depreciation each year, throughout the asset’s “useful” life, until the asset reaches its salvage value (the amount you can sell the asset for parts once it’s no longer of use).
- Declining Balance: The declining balance method of depreciation uses a percentage amount, based on the straight-line depreciation, to account for the fact that an asset loses more value later on in its life.
- Double-Declining Balance (DDB): The double-declining balance method of depreciation is the straight-line depreciation rate, multiplied by 2.
Amortization is the process of paying off a debt over time in a cadence of planned and scheduled payments of principal and interest. Amortization refers to the business practice of paying off debt. It can also refer to an accounting method of dividing that debt and spreading it out over time so that it’s not on a business’s books in a single lump sum at the time that the debt is incurred.
11. Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)
EBITDA, a common metric for tracking a startup’s profitability, stands for earnings before interest, tax, depreciation, and amortization. The simplest way to understand EBITDA is that it’s revenue minus operating expenses.
A small business’s EBITDA can become important if the company is a startup seeking investors or if the business is owned by a venture capital (VC) parent company. In day-to-day operations, most small business owners won’t need to use EBITDA. Still, it’s a term that gets thrown around a lot—especially in the age of tech startups becoming tech giants—so understanding what EBITDA is and how it works will round out your financial knowledge.
How to Calculate EBITDA
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization
Net income is calculated by subtracting expenses from your gross income. Taxes, depreciation, and amortization are typically included in a business’s expenses, so to calculate EBITDA, you add those expenses back in. This is the simplest method for calculating EBITDA. You can also calculate EBITDA using operating expenses. This method requires more steps (If you want to learn how to do it, you can consult our EBITDA guide).
What EBITDA Can Tell Us About a Business
EBITDA demonstrates what a business can do, rather than its complete financial picture today. Many scaling startups take on large amounts of debt to make it possible for them to achieve their desired growth. That debt makes the business unprofitable in the short term. Because that debt is removed in an EBITDA calculation, we can get a sense of what kind of profitability that business might have once the debt is settled.
EBITDA-Related Terms and Calculations to Know
- EBITDA Margin: EBITDA margin shows the company’s profitability as a percentage of revenue. (EBITDA Margin = EBITDA / Revenue)
- Adjusted EBITDA: Adjusted EBITDA accounts for anomalies particular to a given business, making it easier to compare a business to the industry as large (Adjusted EBITDA = EBITDA +/- Adjustments)
- EBIT: EBIT shows a company’s core operational profits without the costs of interest and taxes. (EBIT = Net Income + Interest + Taxes)
- EBITDA-to-Interest Coverage Ratio: EBITDA coverage ratio measures whether or not a company is profitable enough to pay off its debts (EBITDA-to-Interest Coverage Ratio = EBITDA / Total Interest Payments)
- EBITDA Multiple: EBITDA multiple measures a company’s ROI. (EBITDA Multiple = Enterprise Value / EBITDA)
12. Customer Acquisition Cost (CAC)
Customer acquisition cost (CAC) refers to the amount of capital a business spends to acquire a new customer. CAC includes the total amount of sales and marketing resources dedicated to acquiring that customer, along with related property or equipment that you need in order to make the sale and convert the customer. Because many businesses now use targeted online advertising, it’s possible to get a more specific CAC (and in many cases, online advertising lowers CAC compared to broader advertising efforts like TV or print ads).
The lower your CAC, the more profitable your business can be. What makes for a good CAC varies from industry to industry. Some sectors have higher CACs, especially in those where you have to compete for customers. In those cases, you want to make sure that you have a solid ratio between your CAC and the customer lifetime value (LTV). This ratio is referred to as unit economics and is discussed in more detail below.
What’s Included in Customer Acquisition Costs (CACs)
- Direct advertising costs (ad spend)
- Creative costs
- Production costs
- Inventory costs
- Marketing team salary/pay
- Sales team salary/pay
A Simple Customer Acquisition Cost Formula
CAC = (Cost of Sales + Cost of Marketing) / Number of Customers Acquired
13. Customer Lifetime Value (LTV)
Customer lifetime value (LTV) measures the value of a customer over the whole lifetime of the customer’s relationship with a brand. A regular, repeat customer will have a high LTV, whereas a customer who makes one purchase and then never engages with a business again will have a low LTV. As you can see, it’s in a business’s best interest to increase their LTV, especially because acquiring new customers can be such a costly endeavor.
How to Calculate Customer Lifetime Value (LTV)
Customer Lifetime Value = Average Order Total x Average Number of Purchases in a Year x Average Retention in Years
Why Customer Lifetime Value Matters for Entrepreneurs
If you run a subscription business, then customer lifetime value will be the best way to track your relationship with a customer over time. In general, LTV provides businesses with a way to track the value of their relationship with a single customer over a longer period of time, typically more than one year.
Customer lifetime value can also give you an indication of what kind of ROI you’re getting from your customer acquisition costs (CAC). We’ll discuss that more in the unit economics section below.
14. Unit Economics
Unit economics refers to a business’s revenue and expenses related to an individual product, or “unit of production.” To calculate the economics of an individual unit, you first need to determine what a “unit” is in the context of your business. For most businesses, a single customer will be considered a unit. To calculate the unit economics for a business, you need to determine how much it costs to acquire a unit (i.e. customer) and how much value that unit will generate for the business. Another way to understand this is that you need to determine the customer lifetime value (LTV) relative to your customer acquisition cost.
Unit Profitability Formula
Unit Profitability = Customer Lifetime Value – Customer Acquisition Cost
Why Unit Economics Matter for Entrepreneurs
Unit economics gives you a sense of how effectively the money that your business is spending to acquire customers is working for you. In an ideal world, you’re maximizing your LTV and minimizing your CAC, but that’s not always the case. Analyzing your unit economics can give you a sense of where your challenges and opportunities are. CAC and LTV each give you valuable information about your business, but they can give you the most actionable insights in relation to each other.
15. Debt-to-Equity Ratio (D/E)
A business’s debt-to-equity ratio—also referred to as its risk ratio, gearing, or leverage—is a calculation that compares the company’s liabilities to the shareholder’s equity. The debt-to-equity ratio indicates how much a business is financing its operations through debt, as opposed to owned funds.
How to Calculate Debt Equity Ratio
Debt-to-Equity Ratio = (Short Term Debt + Long Term Debt + Other Fixed Payments)/ Shareholder’s Equity
When a Debt Equity Ratio Matters for an Entrepreneur
You will really only need to worry about a debt-to-equity ratio if your business has external investors and/or external debt. The D/E ratio provides information about the level of risk a business faces as a result of where the funding for its operations comes from.
16. Business Credit
Just like people have credit scores, businesses have credit scores, too. The business credit score for your business is an important metric that will affect your business’s ability to qualify for financing. The range for business credit scores extends from one to 100. Business credit is used by lenders to determine a business’s creditworthiness.( i.e. how likely they are to repay the loan). Having a solid business credit score will expand your business loan options and allow you to qualify for lower rates.
Factors That Affect Your Business Credit Score
According to Experian, these are the top factors that will affect your credit score.
- The number of years your company has been in business
- Lines of credit from the past 9 months
- Any new lines of credit that have been open
- Liens and collections from the past 7 years
- One-time payment history
How to Establish Business Credit
First, you need to make sure that your business is an established legal entity. Until it is, it can’t start establishing business credit. Business credit cards are a popular, flexible, and accessible way for a business to establish a credit history. Similar to personal credit cards, paying off your business credit card balance in full every month will help you build good credit. You can also build a credit history by working with a credit line from vendors, suppliers, and retailers.
Take Your Entrepreneurial Expertise to the Next Level
Ready to take your business expertise to the next level? Check out our free trainings to help you get up to speed on all the other topics you’ll be expected to know as a business owner. Want a more in-depth financial education? Our course Finance for Founders will teach you how to structure your business finances.