“The chief business of the American people is business.”
-Calvin Coolidge[1]
Content created by Darin Gerdes. Copyright Great Business Networking.
As a college sophomore I took a criminal justice class that defined the language of the field. It opened my eyes to what was happening around me. As a child, I would watch the news, but I was always confused by technical language. For example, a reporter might say “A grand jury indicted a Harold Lee Smith on three felony counts of larceny,” but I heard something like “A really bad guy was just sent to jail by a really important jury.” What the reporter actually said was that a jury believed that there was enough evidence to send Harold to a trial for three separate charges of stealing something expensive.
Many business people have only vague ideas about common financial terms. You need to understand the basics of business if you plan to rise in your organization. My goal here is to provide you with the vocabulary of business as it relates to accounting and finance. I am not trying to make you an expert, but I will try to provide you with enough familiarity that you understand what is going on when financial matters are being discussed.
According to Dawn Fotopulos, a business professor at The King’s College in Manhattan, and the author of Accounting for the Numberphobic, “If you want to be successful at managing a business, you need to become proficient at handling certain numbers. Put simply, you need to be able to read and understand your financial dashboard.”[2]
In the next few lessons, I will try to help you make sense of the instruments on the financial dashboard. As we proceed, let me assure you that if you do not love the numbers, that’s okay. I don’t either. I prefer to focus on people. However, I don’t want your lack of love for financial concepts to limit your potential in business. In this lesson we will review basic terms that will help you make sense of those instruments.
The Top Line vs. the Bottom Line
You’ve undoubtedly heard the term: “the bottom line.” Perhaps you’ve heard a commentator on the evening news say that, “greedy CEOs only focus on the bottom line.” What is the bottom line?
The bottom line is the last line on the Income Statement. The Income Statement is one of three major accounting documents that managers use to stay in control of the business (the other two are the Balance Sheet and the Cash Flow Statements). We will talk about these in the next lesson, but for now, all you need to understand is that the Income Statement tells you if you are making a profit. “If the number on the bottom line is positive, you’re making money.”[3]
So what’s the top line? The top line is for sales (sometimes called revenue). If you increase sales, the top line reflects that growth. “When people refer to ‘top-line growth,’ that’s what they mean: sales growth.”[4]
Growth in sales is generally good, but you must be cautious. It’s possible have a great top line but still have a terrible bottom line. If that’s the case, you might have a problem with operating efficiency.
You should know one more thing about the top line. When companies are described in terms of size, certain metrics are common. If you hear that a company has “done ten million dollars,” they are talking about ten million dollars in sales—the top line. That may or may not be impressive. You still don’t know much about that company’s profitability until you know their bottom line. Many companies that have great sales continue to lose money, year after year. Of course, that kind of loss can’t go on forever.
Gross vs. Net
Accountants use the terms gross and net to distinguish between figures before expenses and after expenses have been taken out. It’s gross margins, gross profits, and gross revenue tell you part of the story. The other part of the story is told when you calculate net margins, net profits, and net revenues.
You’ve seen this in your own paycheck. If you take all your paychecks over the course of the year and add the figure for gross pay, you get your annual salary—the one written in your contract.
For example, Bob is a consultant who makes just over $72,000 a year. He wonders why he is struggling to pay his bills.
He is paid twice a month. Every time he is paid, his gross pay (what he earns according to his contract) is $3,000.95. However, after all of his expenses are taken out, he only keeps $1,888.00 or $45,312 annually in real purchasing power.
Source: Bankrate.com net to gross paycheck calculator. http://www.bankrate.com/calculators/tax-planning/net-to-gross-paycheck-tax-calculator.aspx
Variable Expenses vs. Fixed Expenses
When you create a product, there are certain costs associated with creating that product such as materials and labor. You only pay for those costs when the product is made, these are called variable expenses or Cost of Goods Sold (COGS) or Cost of Services (COS) in a services business.
In contrast, other costs are paid regardless of whether you produce or fail to produce. For example, you have to pay for the building whether any business activity is conducted or not. This is called a fixed expense or overhead. Overhead accounts for all additional expenses not directly related to producing the product.
Operating vs. Capital Expenses.
The operating budget will include the variable and fixed expenses discussed above. However, managers often separate the purchase of big-ticket items from their operating budget. The operating budget normally lasts for a year, and that year does not necessarily start on January first. That 365-day time period is called a fiscal year and it could start any time. At my university, for instance, the fiscal year begins in June and ends on May 31st. That makes sense for a university.
The really large, long-term expenses are called capital expenses, and these expenses are tracked over a much longer timeframe.
Value vs. Price
I talked about the difference between value and price in a previous lesson, but it’s worth repeating. Value is not the same as price. The value that you set on the thing may be wildly different than the price.
Let’s examine this first from the buyer’s perspective. A few ounces of caviar may cost a few hundred dollars. I don’t value caviar, so I do not buy it. To me it has a low value and a high price. On the other hand, I am a big fan of books. I have purchased small volumes of books for the price of caviar. Value, like beauty, is in the eye of the beholder. The value of a think is not the same as price. Value may tell me what I am willing to pay. Price tells me what I must pay to obtain it.
For example, if I value a book at $20, and the price is $40, we have a mismatch. Unless I simply must have the item (e.g., a required textbook for a class, prescription drugs, legal fees, etc.), I will not buy it at that price. However, if the price is $12, and I still value it at $20, I am more likely to buy. This does not mean that I will buy because other factors come into play including awareness and the intensity of my desire to own it. The point is that I must value the purchase more than the purchase price.
Margin
Now let’s continue to look at this issue of value and price from the seller’s perspective. The seller must set his price so that he can make a profit. He cannot set the price below his costs or he will lose money on the transaction.
Let’s examine a simplified example. Suppose it costs $10 to produce a book. In reality there are many more variables to the price such as royalties, distribution channels, and projections about the number of books sold at a particular price, but we will set those aside for the moment. If the seller charges $12, his margin is $2. If he could sell the book for $40, he would earn $30 in profit, but as we learned above, buyers are not likely to spend that much.
When businessmen talk about how much profit they are going to make on a particular product, they commonly use the word margin. Margin is, “the difference between a product’s (or service’s) selling price and the cost of production.”[5] All other things being equal, the seller would prefer a large margin and the buyer would prefer a lower cost.
Gross margin is the difference between your revenue (think top line) and how much it cost to produce the item. Accountants call this latter figure the Cost of Goods Sold (COGS) or Cost of Services (COS). Then, they subtract overhead expenses over the same time period and taxes. Net margin is the difference “between the top and the bottom lines.”[6] You must keep track of your margins to know if you are profitable, or more precisely, to know what items are profitable. Remember, “no margin, no mission.”
Breakeven Point
A lot of assumptions and calculations go into making business decisions. Pricing the book requires a number of calculations. How many should be printed? Should we use a distributor? How many will we sell? At what price? How long will it take before we break even?
“The point at which a business ‘breaks even’ occurs when its net income is neither positive nor negative; rather it is zero.”[7] After that point, each sale should be profitable.
This will play out differently in different industries. It will be different for small manufactured products than for software or prescription drugs that have large research and development costs to recoup. Your break-even point may be different, but you still have a breakeven point, and knowing that number is helpful.
Profit vs. Cash
We have established that value is not the same as price. Similarly, profit is not the same as cash. It may be the same if you only buy and sell in cash, but it is unlikely. For everyone else, customers are sent bills that show up in your financial statements as accounts receivable, and suppliers send you bills that they call accounts payable. Because it takes time between completing a sale and actually getting paid, if you are not careful, you may run out of money even if your are profitable. This is why, “cash is king.”
Many entrepreneurs have gotten into financial trouble because they failed to collect accounts receivable fast enough to pay their accounts payable. Sometimes they are slow at collecting their bills. At other times, their own system creates the problem. This happens when the business has to pay up front for the raw materials that go into their final product. Then, they must wait for the product to sell before they get paid for their products. The space in between is a dangerous place to be and many entrepreneurs have gone bankrupt because they did not manage cash flow.
Asset vs. Liabilities
Assets are things that you own. Assets include cash, products, machinery, and real estate. Assets are the tools and materials you need to produce your products and grow your business. Kevin O’Leary of Shark Tank fame often describes his dollars as little soldiers that he sends out into the world with orders to come back with friends. That’s a good analogy.
Robert Kiyosaki, author of Rich Dad, Poor Dad, offered a similar illustration: “Think of it this way, once a dollar goes into your asset column, it becomes your employee. The best thing about money is that it works twenty-four hours a day and can work for generations.[8]
There are different types of assets. Short-term, or current, assets are sometimes called liquid. They are easy to liquidate quickly if you had to pay off your debt. Financial assets include stocks, bonds, and other financial resources that help the business produce. Fixed assets are more difficult to liquidate. You might be able to sell that specialized piece of machinery you need to create your product, but there’s a small market, you are not likely to get market value for it, and it’ll take time to sell.
Liabilities are things that own you—they make a claim on your future income. They are the debts you pay for those assets that you have purchased. They stalk your future income until they are paid.
Not all liabilities are bad if they are managed appropriately. For example, the liability (debt) that you have for an expensive machine (an asset) that produces your product (another asset) may pay for itself many times over.
You just have to keep clear in your mind what is a true asset and what is a liability. For example, the bank will record your home as an asset, but as Kiyosaki explained,
To become financially secure, a person needs to mind their own business. Your business revolves around your asset column, as opposed to your income column. As stated earlier, the Number-one rule is to know the difference between an asset and a liability, and to buy assets. The rich focus on their asset columns while everyone else focuses on their income statements. . . .
When downsizing became the “in” thing to do, millions of workers found out their largest so-called asset, their home, was eating them alive. Their “asset” was costing them money every month. Their car, another “asset”’ was eating them alive. The golf clubs in the garage that cost $1,000 were not worth $1,000 anymore. Without job security, they had nothing to fall back on. What they thought were assets could not help them survive in a time of financial crisis.[9]
Sometimes there is a difference between the way an accountant views an asset and the way you should see an asset. Kiyosaki takes issue with the way that accountants view assets. Many entrepreneurs make the mistake of leasing a large office and purchasing fancy office furniture, in an effort to impress potential clients. Specialized machines in the back that product your product are real assets. The furniture is an asset on paper, but a liability in practice. Even if you own the furniture, it has negatively affected the cash you have on hand. Kiyosaki concluded that, for all practical purposes, a liability will eat you but an asset will feed you.[10]
Return on Investment (ROI)
Return on investment is another common financial term that we need to define. Because I plan to devote an entire lesson to this, I’m not going to spend a lot of time here except to say that return on investment help you measure the degree to which a particular course of action is profitable.
Summary
Here is a brief summary of what we have covered. The top line represents sales and increased sales demonstrates potential growth. The top line (gross) is what you have before you subtract expenses and the bottom line represents profit (net). Do not confuse price with value or you may not make a profit. Do not equate profit with cash or you may run out of money. You want to accumulate more assets that feed you than liabilities that will eat you. While everything you own is an asset, what you really want are assets that help you produce more efficiently. Keep track of important statistics—fixed and variable costs, break even, and return on investments. Business is easy to understand but difficult to execute.
Actionable items:
How is your top line? How is your bottom line? Can you explain what’s causing each to grow or to decline (if you can’t explain it, you don’t understand it).
Do you know your margins for your products? Which are most profitable?
End Notes
[1]Coolidge as cited in Sobel, R. (1988).Coolidge and American business.Coolidge Foundation. Retrieved from https://coolidgefoundation.org/resources/essays-papers-addresses-35/
[2]Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 1)
[3]Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 5)
(p. 5).
[4] Berman, K., Knight, J., & Case, J. (2006). Financial intelligence: A manager’s guide to knowing what the numbers really mean. Boston: Harvard Business School Press. (p. 41).
[5] What is ‘margin’ (n.d.).Investopedia. Retreived from http://www.investopedia.com/terms/m/margin.asp
[6]Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (pp. 197-198).
[7]Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 72).
[8]Kiyosaki, R. T., &Lechter, S. L. (2000). Rich dad, poor dad: What the rich teach their kids about money– that the poor and middle class do not! New York: Warner Business. (p. 79).
[9] Kiyosaki, R. T., &Lechter, S. L. (2000). Rich dad, poor dad: What the rich teach their kids about money– that the poor and middle class do not! New York: Warner Business. (p. 75).
[10] Kiyosaki, R. T., & Lechter, S. L. (2001). Rich kid, smart kid: Giving your child a financial head start. New York: Warner Books.