You’re a business owner who wants to create a successful brand and share your products and services with the world. But in order for it to become truly successful, it’s vital you understand the financial terms associated with running a business.
Not everyone enjoys managing their money — some of us aren’t successful at it, or we just don’t have the time. Either way there are some money basics that you need to know. Why? Because you can’t achieve your business goals if you remain uneducated about your money. Ignorance is not bliss in this case.
Below are simple financial terms that every small business owner should know.
1. Gross Profit vs. Net Profit
Gross profit is different from net income and can mean the difference in paying a lot more taxes to the IRS or state if you don’t know how to distinguish them. Gross profit is the amount you make from your salary, gross receipts, product sales, and other income before things like taxes, insurance, investments or any other expenses are taken out. It’s your base salary/hourly wage.
On the flip side, net income/profit is what you actually receive when you get your paycheck, or the funds that are deposited into your account after fees have been taken out. It’s the income you use to live on, and have available for household and living expenses.
A simple way to see the difference of gross profit vs. net profit is to input your business figures onto a Schedule C tax form. Part one, line 7, will determine your gross income figure, while part two, line 31, will explain your net profit amount.
2. Fixed vs. Variable Expenses
Fixed business expenses are typically the same amounts that recur every single month. For example, the money you pay to rent a business space or storefront is always the same amount each month and can be easily projected within your budget.
Variable expenses are much more broad and can include both essential and excessive spending. Which makes variable expenses a lot more unpredictable and difficult to budget for. Things like losing a big client, a financial emergency or other life tragedy, are considered variable expenses.
Your goal as a business owner is to limit your variable expenses so you can accurately project — and plan for — fixed expenses every month.
3. Ordinary Income vs. Capital Gains
Ordinary income is made up mostly of wages, salaries, commissions and interest income. Although ordinary income is taxed at the highest rate, it can be offset by regular tax deductions.
Capital gains is income that’s generated from buying and selling other investments or assets, and is taxed in a different way than ordinary income. There are many different types of business avenues that produce investment income, like stock market investing, savings accounts, and purchasing other tangible assets like art or collectibles. Unlike ordinary income, capital gains income can only be offset by capital losses.
Depending on whether your capital gains are long-term or short-term, you could end up paying a relatively small amount in taxes. Which makes capital gains investments and ventures a lot more attractive to many business owners.
4. Self-Employment Tax and QET’s
If you’re new to the business world, you may not fully realize that on top of paying regular Federal Income tax rate, you’re also responsible to pay Medicare and Social Security tax.
When you work for an employer, they pay ½ of this tax, leaving you to pay the other half. But when you’re the boss you have to pay the entire 15.3% of Self-Employment tax (SE tax). When you add this to your effective tax rate and you could end up owing a lot of tax at the end of the year.
As a small business, you’re working with a tight budget, but you still have to set aside money to pay quarterly estimated tax payments (QET’s), so you don’t get slammed with a large tax bill at the end of the year. The IRS requires that taxes be paid on income as it’s earned, which is why a traditional employer withholds taxes from earnings each paycheck.
I set up a separate savings account labeled “taxes”, where I set aside 30% of each month’s earnings, to be paid out each quarter. This not only makes it easier to pay taxes once tax time comes, but helps your often irregular business budget prepare for the QET’s that need to be paid each quarter.
If you don’t pay your business taxes on a quarterly basis, you’ll get slapped with fees, if you expect to owe more than $1,000 in taxes at the end of the year. And let’s face it, no one likes to pay extra fees to the IRS.
5. Equity and Assets
The definition of assets and equity is very similar and in fact, they compliment each other. The value of your vehicles, houses, property and any other items of value are considered assets. Any cash in the bank, investments and other financial accounts are assets too. In the event that everything needs to be liquidated, it’s important to know the total value of all your assets, so you can take care of any emergencies that arise.
Equity is ownership of an asset after the debt balances are paid off. For example, if you’re paying down a mortgage and only owe $30,000 on it, the difference between that debt balance and what the property is worth, is the equity.
6. Debt Balances
It doesn’t matter if you run a small business or a large corporation, it’s important to keep tabs on the amount of debt you’ve accumulated. How much credit card debt do you have? Do you have business loans or lines of credit you’ve taken out? These need to be regulated often. You don’t need to evaluate them every day, but you should do a quick weekly checkup.
Make sure your payments are being posted properly and that people aren’t charging you extra fees. If you give your employees or team members business cards or access to your accounts, make sure they are using them properly. Additionally, checking in with your debt balances regularly and watching the balances go down every month is very motivating and will keep you on track towards financial freedom.
7. Net Worth
This is one of the most commonly overlooked financial stats, but it’s very important. Net worth is determined by adding your loans (the debts you owe) with your assets (the valuables you own).
If you have more debts than assets you will have a negative net worth and if you own more property than your debts, your net income will be positive. As a business owner, you should always strive towards a positive net worth — meaning owning more assets than you debts.
Know These Financial Terms to Be Successful With Money
At the end of the day, knowing your financial standing can give you peace of mind and help you get a grasp on your money. Even if you only look at your finances every month or every quarter, you want to regularly stay on top of your financial balances.
You don’t need to be an expert and to handle your business money perfectly. Just familiarize yourself with these basic financial terms and your business will have a much better chance of becoming successful.