Basic Financial Concepts Every Small Business Owner Should Know

Running a small business means you are handling multiple responsibilities. The product or service you sell is only one part of the equation – there is an accounting and finance component to running a business that can differentiate a successful business from a struggling business.

Accrual vs. Cash basis

There are two ways you (or your accountant) can choose to handle your accounting. First is cash basis. When you receive cash, or pay out cash, that influences your books and affects your tax liability. Accrual is very different. With accrual, you can have income on your books before you have actually been paid. This means you would be responsible for paying taxes on money that you may not have even received yet. On the flipside, expenses can be incurred before you actually pay them out – meaning you can reduce your tax liability before paying out.

Many small businesses would be better off choosing a cash basis. If you're just starting out, you don't want to pay taxes on money you have yet to receive – cash is especially important to you at this stage. However, accrual gives a much better picture of what's going on with your company (imagine if shareholders found out about billion-dollar Boeing contracts only when Boeing received cash for them). Your accountant can help you pick the best method.

Time Value of Money (TVM)

This is at the core of finance. I find the best way to explain TVM is using an example. Let's say you sell me a widget worth $100, and I tell you I can either pay you $100 today or pay you $110 in one year. Which option is best for you? The answer is…it depends. Let's say you decide to take $110 in one year because it's more money. In the meantime, I put the $100 I was going to pay you into a bank account earning 15% interest annually. At the end of the year, I have $115. I pay you $110, and I keep the remaining $5.

Had you taken the $100 today, you could have put the money in a bank account yourself and had $115 after one year instead of only $110. But if interest rates were at 8%, then you would be better taking $110 one year from now because $100 today would only be worth $108 in one year (less than $110). $5 and $2 may not seem like a big deal, but if you consider the impact of this on larger, frequent transactions - the difference is significant.

The time value of money tells you that $1 today is worth MORE than $1 tomorrow. The reason is because you can invest that $1 today and have it be worth more tomorrow. What does this mean for your business?

You want to hold onto your money as long as possible and receive money as quickly as possible. You can do this by paying your bills right before they are due and finding ways to have your customers pay you as soon as possible. Keep in mind this ignores other psychological factors like your vendors being happy if you always pay them immediately (which could lead to more flexible payment terms or even discounts).

Risk and Return

The more risk you take, the more return you should expect. If given two options with the same return, you should always choose the option that has the least amount of risk. Likewise if given two options with the same level of risk, you should always choose the option that has the highest return.

The idea is that if you are going to take on more risk, you should be compensated for doing so. It's not really possible to get the lowest level of risk available along with the highest level of return. This concept seems straightforward, but it's extremely valuable. I use this risk/return relationship when quoting fixed-fee projects for example.

Opportunity Cost

Opportunity cost is the cost associated with choosing one option and forgoing another. For example, a high school graduate has the option of going to college or working full time. If she chooses college, the cost of her decision isn't just the cost of tuition and books, but the money she is missing out on by not working fulltime for four years while she is in school. If she chooses to work full time, the opportunity cost is the amount of money she would have made (in excess of her regular pay) for having a college degree for the rest of her life. So let's say she can make $10/hr without a college degree, or $15/hr with a college degree. She needs to take into account the $5/hr she will lose out on for the rest of her life by not going to college now. There are also non-financial opportunity costs, like the free time she is giving up while she is doing homework or studying for exams.

Opportunity cost isn't an actual outflow of cash, but you should treat it as an actual outflow when comparing options.

Relevant Costs

Business decisions have relevant and irrelevant costs associated with them. Let's say you are considering fixing your old, beat up car or buying a new one. The amount of money you have put into your car over the last ten years is irrelevant (called a sunk cost). It makes no difference in your decision today. That money is gone. Psychologically this has a big impact on us when we make decisions ("I've already invested so much money into ___"), but leaving these out ensures we make better decisions.

The Impact of Taxes

Taxes are a very real business expense. You cannot make the best possible decision for your business unless you take into account the impact of taxes. I give a lease vs. buy example towards the end of this post that shows how important this is. Similarly, you should consider how you can reduce your tax liability. Talking with an accountant could save you big money if he can help you make small changes that reduce your tax liability.

Cost of Capital: Equity vs. Debt

Many small businesses and entrepreneurs who need to raise money immediately think of venture capital, angel investors, or another form of equity (equity meaning you give up some ownership of your business in exchange for cash). But bank or family loans are usually much less expensive. I would recommend a business owner to seek out these alternatives first.

Let's say your business takes off and is the next Google (for the sake of example). If you gave up equity, think of how much the money you were given cost you. Giving up even 2% of a company worth $100 billion is a lot of money! With a loan, you are only obligated to pay the amount borrowed plus any interest – regardless of how successful your company becomes.

But just looking at the tax implications, lets say you know that equity will cost you 10% and debt (a loan) will also cost you 10%. Even though the rates are the same, debt is still cheaper! The interest you pay on the debt reduces your tax liability. So if your tax rate was 28%, debt would actually only cost you 10% x (1-28%) = 7.2%. We subtract the tax rate out from 1 because the government is essentially covering 28% of the cost (interest shelter). You're only paying 72% of the cost. You don't have the same tax benefits with equity.

Example 1: 2/10, n/30 Invoices

Often you'll receive an invoice with the terms 2/10, n30 which means the payment is due in 30 days, but you'll receive a 2% discount if you pay within 10 days. The vendor is trying to encourage you to pay early. By not taking this discount, you are essentially paying an annualized interest rate of 37.24% ([0.02 / (1 – 0.02)] x (365/20)] If you have the money, you are much better off taking the 2% discount every time and saving yourself the "interest charge."

Example 2: Lease vs. Buy Decision

I'll end this post with an example that demonstrates the various tradeoffs available in what (at first) seems like a simple business decision.

Imagine you need a company vehicle for your business. You have two options: lease the vehicle or take out a loan and buy it. Business owners may be tempted to just compare monthly payments and decide – but there is so much more to this decision than that.

• Taxes (Interest and Depreciation Shelters)
  Taxes can range from 15% to something much higher like 40%. In a lease vs. buy decision, each carries different tax benefits. If you lease, you can write off the entire lease payments to reduce your tax liability. If you buy, you can only write off the portion of the payment that is interest (called an interest shelter). You also have depreciation shelters if you buy. Depreciation is the loss in value of your vehicle. You don't actually pay out depreciation (non-cash expense), but the loss in value is considered an expense for tax purposes and saves you money on taxes.
• Residual or Salvage Value
  At the end of the vehicle's useful life, you will have a salvage value associated with that vehicle if you buy. If you lease, the leasing company will have a residual value (meaning they can recondition the vehicle and then lease or sell it – that's one reason dealers push leases). If the vehicle has a salvage value, you can actually get some cash back at the end of the vehicle's useful life that you should take into account when deciding whether to lease or buy.
• Other considerations
  What if your business takes off in 12 months and you'd like to pay off your lease or loan obligations early. If you pay your loan early, you save yourself the remaining interest that you would have otherwise paid had you not paid early. With a lease however, you are contractually obligated to pay the lease amount for the lease period. The lease inherently has principal and interest worked into it, but it is a fixed payment for a fixed period of time. Even if you pay the lease off early, you are still contractually required to pay the entire contract amount. There is no savings here.

Business decisions occur daily, and there is always more than just one option. Understanding some of these basic financial concepts can ensure you increase the likelihood of selecting the best option. The point of this post isn't for you to learn how to calculate ROA or to build an Excel model on a lease vs. buy decision – an accountant or outsourced CFO can do that for you. The point of this post is to put you in the right mindset so you are aware of the various components and their impact on your business.

Do you have any examples of business decisions you've made that involved any of these concepts?