Understanding the basics of business finance

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Understanding the basics of business finance

Mid-level and front line managers often do not know the financial implications of the performance of them and their team. This is a lost opportunity – these managers are often the conduit for the high level strategy down to the day-to-day tasks designed to implement that strategy. If these managers were able to convey some of the financial implications of the work their team does it would contribute to a greater sense of collective investment in the organisation.

Here are some basic tips to improve the financial understanding of yourself and your team.

  • Don’t be overwhelmed by the task of understanding the basics of your organisation’s finances: it’s mostly addition and subtraction, occasionally with multiplication and division – for the basics of finance you don’t need to understand complex equations or algorithms.
  • Understand foundational financial concepts and terms: Joe Knight, a partner and senior consultant at the Business Literacy Institute and the coauthor of Financial Intelligence, told Harvard Business Review that the most important finance concepts to grasp are “how to measure profitability, EBITDA, operating income, revenue, and operating expenses”:
    • EBITDA: EBITDA stands for ‘earnings before interest, tax, depreciation and amortization’. It refers simply to the base line earnings of a company. It is useful to show how operations alone are affecting a company’s performance without having to factor in external effects such as tax rates which are determined by the government.
    • Operating income: Operating income is a helpful comparative to EBITDA – it is the income left over when operating expenses are deducted.
    • Operating expenses: Literally, the costs associated with the business operating e.g. employees’, rent for the premises, office supplies etc.
    • Revenue: Revenue is the total amount of money generated by the sale of the goods or services which are the company’s primary operations.
    • Measuring profitability: see profitability margin below.
  • Understand the connection between operations and financial performance by knowing the key metrics of your company. Knight says “There are four ratios common in every company: profitability, leverage, liquidity, and operational efficiency”:
    • Profitability: Profitability ratios are simply a business’s ability to generate earnings compared with its costs and other expenses. The gross profit margin is the amount left before overheads are paid, and the net profit margin is the amount remaining once those costs are paid. Net profit margin differs from operating income because it takes into account all expenses (and debts and assets), not just those associated with operating.
    • Leverage: Leverage is an investment strategy of using borrowed money to invest with. By putting more money in, there is the potential for greater returns on the investment.
    • Liquidity: Liquidity describes the extent to which something can be quickly bought or sold in the market without affecting its price. Cash is considered the most liquid asset (because its value is simply the the dollar amount), while real estate for example is a less liquid asset because the process of selling or buying it can affect its price. In the case of a company, accounting liquidity refers to how easily the company can meet its financial obligations with its liquid assets.
    • Operational efficiency: An efficiency ratio measures how well a company can use its assets to generate income. There are quite a few different ratios that can be used measure efficiency, but one example is how quickly a company can collect money from its customer after a sale is complete. When a customer purchases a television instore and pays upfront, that sale has very quickly generated income for the company. But if the television is bought online using a staggered payment plan, the income will be generated at a slower pace.

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