Understanding the Basics of Business Finance: A Beginner's Guide

June 6, 2023
The Profit Plot


Welcome to episode one of the Profit Plot. I am your host, Jeremy Millar. I'm the CEO and co-founder of an accounting firm called Amarlo, where our goal is to help small businesses understand their financial story.

On the Profit Plot, our goal is to help you unlock your small business's financial story by unpacking one complex financial topic at a time.

You know, as an accountant, we see lots and lots of people, lots and lots of small business owners specifically, that just don't understand the complex world of business finance and accounting. Which totally makes sense.

Accountants think strangely; they think within the system of accounting, and that is a foreign language to most people.

But it's a language that, if you have a very basic understanding of, you can get a whole lot of value from. So today on the Profit Plot, we're going to be diving into the basics of business finance and unpacking our Beginner's Guide to Business Finance.

What does it mean? Why is financial control so important for small business owners? And the best practices for understanding the foundations of financial management and business finance in general.

Now, in order to get started, I think we really just need to define our terms. What exactly is business finance? What does it mean, and why is it helpful?

When we talk about finance, we're talking about money, obviously, but what money means and where does it go? How does it come into our business in the first place?

Business finance is really just the practice of allocating and managing money as it flows into the business.

Every business's prime directive, every business at its core, is meant to make money.

In some cases, we're selling a product, and other small businesses are selling a service, and those service-based businesses are creating money in exchange for their time, whereas product-based businesses are exchanging a product for money.

At its core, understanding business finance and unpacking business finance helps the owner of the business or the operator, the entrepreneur, to understand the story behind where that money comes from, and then ultimately where it goes, how that money gets spent, redistributed back to the owners, reinvested into the business, whatever it may be.

Financial control in itself, understanding that business finance bleeds into how we manage our money, where it goes, how we spend it, and what we do with it.

When we understand where our cash goes, it can help us actually implement a lot of strategic planning, can unlock better decision-making, and ultimately it can help us to grow our businesses faster.

Most small businesses operate by the seat of their pants.

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They're not looking at their finances at all. They're maybe checking their bank account every once in a while to ensure that they still have cash in the bank.

That is just absolutely unacceptable.

Having a financial plan, how you're going to spend your money, understanding what next month might look like based on projections from previous months, it allows your business to create direction.

What we've found is that directionless businesses are most prone to failure because they're simply existing with no plan or goal for the future. One of the most important parts of understanding how your business finances behave is unlocking the story behind them.

Understanding where your money is going, how it's moving, where it's coming from in the first place.

And that allows you to create clarity about where you are going to go, how you are going to guide the business as the owner. It brings confidence to the decisions that you're making.

Ultimately, it allows you to unlock a level of control in your business that very few businesses get. It also makes it easier to grow a team, to make a profitable, successful business to achieve the goals that you're looking to grow.

If you think about, oh, can I hire someone? Can I bring on new employees? Can I create new marketing spend? Can I endeavor to grow my business through these different channels? The only way to truly understand those foundational aspects of growing your business is by first understanding your finances to understand exactly how your finances are performing and where they are projected to go.

You know, Warren Buffet once said, "accounting is the language of business," and it's easiest to understand the foundations of business finance when we actually understand accounting. Because accounting is simply the organization and communication of all financial information into easily and understandable data.

Accounting is translated into financial documents. These are things like our Profit and Loss, Balance Sheet, Statement of Cash Flows. These documents allow us, when clearly compiled, to guide our businesses. We can see from Profit and Loss, for example, how our business is performing in terms of profit margin.

We can easily identify a break-even number and identify exactly how much money our business needs to make in order to generate a profit. From our balance sheet, we can see how much cash we have at a certain date, how our liabilities are performing. From a statement of cash flows, we can see where the money is flowing in and out day to day.

At the very core of business finance is accounting.

It's the way that our financial information gets organized and communicated. Ultimately, accounting is the very foundation of finance in general.

Now accounting in itself, it could, can be pretty complicated to understand. It's something that not many business owners choose to understand because they don't have the financial background. They think it might be too complicated.

But truthfully, accounting is simply based off of five core accounts. Accounting uses an account system to document how money moves throughout your business, how money flows, or how value flows through the business.

Whether it's cash increasing in the bank because of sales, liabilities being paid off, debt being paid off from the bank, maybe it's expenses that are being leveraged to help you grow the business.

All of that information is being translated into your accounting. Because of your accounting.

There are five different account types, and these are organized in what we call the Chart of Accounts. Now our five different types, we have assets, liabilities, equity, revenue, and expenses.

Assets first primarily are what we own, what the business owns. It's the economic value that our business has available to us for a future purpose.

That means bank accounts, that means cars, that means equipment, that means real estate, whatever it might be. Those are assets because they have an economic value that can be utilized.

Then we have liabilities, and a liability is something that your business owes. It's an item of economic value that you owe to another party, something that you owe to another party in exchange for. Cash or payables or whatever kind of value you are exchanging, liability is simply what you owe.

Finally, equity is typically what's left over when we have our assets minus our liabilities. That is our equity. It's the value within our business that is left over from our assets and liabilities.

It's the value of the business to the shareholders. It's what really drives the valuation of the business when we understand how valuable the business is to the owners.

Then we have our revenue. or income and sales. This is the money that gets generated, that is brought into the business through sales, through product income, through any kind of exchange for a service or product in the form of an exchangeable value of an asset when a sale is made.

We see revenue come in in the form of cash, for example, that cash is something that we give in exchange for a product or service.

On the flip side of that, obviously, we have expenses. We have things that our business is spending, money that our business is spending, or economic value that our business is spending, in exchange for something else.

So whether it's a software to help you write emails better, whether it's janitorial services to make sure that your facility is clean, whether it's rent for the office, whatever it might be, those are expenses, money that we are simply spending.

So, understanding these five account types and their interaction between one another, how assets can flow into reducing liabilities, how assets and expenses interplay, how revenue can help increase your assets, and then ultimately increase your equity in the business by flowing into net income.

All of these things tell a story, and over time, the more time that you spend with each of your financial statements, the more clearly organized these statements are, we can easily understand the story behind each and the thing that your business is trying to tell you in a periodic timeframe.

We can look at things like our profit and loss on a monthly basis in order to see trends, to identify the ways in which our money is being spent, our income is increasing or decreasing. With the time that we're seeing, you know, whether it's a slow season, we might see a decrease in income on our profit and loss.

When it gets busier, we'll see that increase in our profit and loss, but either way, we're seeing the data when we correctly view our financial information.

Now many business owners get caught up in creating a chart of accounts, or they choose to simply not create a chart of accounts, not create something that is customized to their business.

Instead, they create something that is the default, for example, from QuickBooks, and that is extremely lacking. It does not tell the proper story for how your business is behaving. It can only tell a fraction of the story because it does not convey enough information.

In order to get proper information about what's going on in terms of our business' financial position, we need really excellent financial foundations.

These are things like a great chart of accounts, well laid out chart of accounts, identifying all of the different assets, liabilities, equity, revenue streams, and expenses that we have so that we can clearly understand in a concise format what is going on inside of the business from a periodic standpoint.

This enables things like understanding cash management better.

We can then identify how our cash is increasing or decreasing in certain periods like month over month, year over year, even week over week, or day over day. We can identify how that cash is fluctuating.

We can even go deeper into sales and identify from our revenue lines, how our sales are increasing or decreasing depending on the amount that we're selling of each product or service that we might be supplying.

We can see how our debts are being serviced based on the interaction between our assets and our liabilities because we can see cash flowing from an asset like a bank account into paying off a liability like a credit card or a loan.

It allows us to get an excellent idea of what's going on in our business when we have an excellent financial foundation, an excellent accounting foundation with our chart of accounts.

From there, we can then identify using our chart of accounts, our profit.

On our profit and loss the purpose of our profit and loss is to position our revenue and our expenses in juxtaposition. We subtract our expenses from the amount of revenue that we see within a certain period, whether that's a year, whether that's a month, whether that's a week, whatever it might be, whatever timeline that you're looking at.

Revenue minus expenses is what equals profit, and that's an extremely important number for business owners because understanding what we profited can help us then dive into why we made a profit in the first place.

Diving into why we made a profit allows us to understand where our cash came from, where it was spent.

It all comes back again to that foundation.

We need to dive into our income and our expenses in order to properly understand what happened in a given period.

Typically, for most businesses, this is something that occurs on a monthly basis. They'll look at their P&L and they see that income was a certain number and expenses were a certain number, and then of course there was a profit or a loss.

When we see a profit, we know that income was obviously higher than our expenses, and therefore we made money. A loss is when income was lower than expenses.

From a financial perspective, that means that we're drawing then on the assets that the business already held, for example, cash that was existing in the bank account in order to pay for all of the expenses that we had before.

It's this kind of exchange that we need in order to identify whether or not our business is performing properly. Is it worth it as owners, as entrepreneurs, to run a business that isn't profitable for a long period of time? Can you sustain that? How long can you sustain that? How long can you grow before you finally need to turn a profit?

And what goes into doing all of that at its core, understanding the foundations of business finance allows you to answer that question along with our profit and loss, our balance sheet.

Understanding all of these different financial statements we're able to actually create a business budget. And a business budget is actually one of the most important tools for every small business in the world.

Many small business owners operate without a budget of any kind.

They don't understand what they're spending, they don't see what they're making, and therefore they're simply attempting to turn a profit while blind, basically.

They have no clue what is happening with their business. It's evident that hurts them. Ultimately, they have unexpected tax bills. They aren't collecting on invoices. They have many different cases in which they're losing money because profit margin is too low.

Understanding and creating a budget allows us to effectively plan for the future.

If we know that, for example, our revenue is going to be a certain number compared to our expenses in one period, we can then create a budget that allows us to create an average of how many expenses we're going to spend or invest in over the next few months.

For example, in our accounting business, we'd typically track how much revenue we're bringing in for our bookkeeping services.

We look at how much revenue on a monthly basis we're billing for bookkeeping and how much we're actually spending in the form of expenses, and we create a budget based on those figures in order to calculate and project into the future a number based on the past so that we can make decisions about what our business is going to be doing in the future.

We can make decisions about how our business is going to grow, or the marketing that we're going to be investing in, or the expenses that we're planning to take on, the hiring that we're going to do, all of those things because we understand our financial foundation. Utilizing that budget, reviewing that budget.

Once you have enough historical data, once you have any kind of historical data, you can actually make a shift in the life of your business.

Going from not operating with any kind of insight into what's happening in the business from a financial perspective, not tracking anything at all to tracking all of your financial information and then making decisions based on that financial information that can ultimately impact the growth of your business, that can help you become a better operator, that can help you grow faster, that can really make a significant impact in the life of your business.

From a financial, operational perspective, in order to create a really excellent budget, in order to actually have any of the insights that we've been talking about, you need extremely excellent financial operations.

You need a way to capture the data that your business is producing. Your business is constantly spitting out data, whether you know it or not.

You are spending money online with your subscriptions.

You're running payroll.

You're paying rent.

All of these data points are happening. It's important to create a financial operation in which your business' data is getting captured because, with that data, you can then create an extremely useful framework for how your business is going to perform in the future.

Operationally, you should be using an accounting system, setting up that chart of accounts to have a clear and concise chart of accounts in order to communicate a clear and concise P&L and balance sheet, a statement of cash flows.

You should be introducing payroll software that automatically reflects in your accounting system, using expense management tools like Expensify, Melio, or Bill.com in order to actually create an ecosystem in which your financial operations are automatically updated and reconciled so that your business can continue to draw insights out of that financial information.

All in all, business finance is one of the most important aspects of running a successful business outside of first of all, sales.

In order to have an excellent financial operation, in order to have something that really helps make sense of what is happening inside of the business, you need a fantastic foundation.

Creating that financial plan, understanding the story of how income is coming into the business, why that income is happening, and where expenses are going, what you're spending on, how your cash is being handled.

All of these things help give you the control, the clarity, and the confidence for running your business.

Without any of these things, your business is going to be much more chaotic, prone to failure, and clearly much more stressful.

Well, that's all we've got for today. Thank you for tuning into the very first episode of the Profit Plot.

Again, our goal is to help you unlock your small business' financial story, one complex topic at a time, making that complex topic more accessible so that you can be a better small business owner. So that, ultimately, you can grow your business with confidence. I hope that you'll join us next time on the Profit Plot.

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Jeremy Millar
Written by:
Jeremy Millar

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