Basic Financial Terms

The word 'terminology' refers to the language used in a specific field. For example, health, science, and finance all have their own terminology. Knowing the specific terminology of a subject is crucial to understanding industry reports and discussing relevant issues with your peers. Read on for an introduction to basic financial terms in business.

Basic financial terms in business

Revenue, costs, profit and loss, the average rate of return, and break-even are basic financial terms you can find in most companies' documents and financial reports.

Let’s take a closer look at each of them:

Revenue and costs

Here's the formula for calculating revenue:

$Totalrevenue=PriceXNumberofunitssold$

$\mathrm{<a\; data-course-subject-id="5702215"\; data-summary-id="36777319"\; href="https://www.studysmarter.co.uk/explanations/business-studies/nature-of-business/revenue/">Revenue</a>}=\mathrm{Price}\times \mathrm{Number}\mathrm{of}\mathrm{units}\mathrm{sold}$

Total costs consist of variable costs and fixed costs:

• Variable costs are costs that change as the number of goods or services a business produces changes. For example, wages (the amount employees are paid per hour), packaging, utilities, and raw materials are variable costs.

• Fixed costs are costs that a company must pay each month regardless of how much it produces. Rent, salaries, insurance, interests, depreciation, and property taxes are common examples of fixed costs.

Here's the formula for calculating total costs:

$Total\mathit{}costs\mathit{}\mathit{=}\mathit{}\mathit{(}Variable\mathit{}costs\mathit{}per\mathit{}unit\mathit{}X\mathit{}quantity\mathit{)}\mathit{}\mathit{+}\mathit{}fixed\mathit{}costs$

Profit and loss

Profit occurs when a business’s revenue is greater than the total cost. By contrast, a loss happens when the total costs exceed total revenues.

A surplus of revenue is vital to business growth, as the extra funds can be used to purchase new machinery, more raw materials or hire more employees. Repeated losses can bring about a shortage of capital and result in business failure.

Here's the formula for calculating profit:

$Loss\mathit{}or\mathit{}Profit\mathit{}\mathit{=}\mathit{}Revenue\mathit{}\mathit{-}\mathit{}Total\mathit{}costs$

The average rate of return

Investment in machinery, workforce, inventory, etc. is vital to a business’s growth. How can a business decide when to make an investment?

A good investment is one that brings the company more financial gain than if it had put the money elsewhere. For example, if a business knows it can get 1% interest from its bank account, any investment that generates more than 1% in profit is considered a good investment.

Here are two steps to calculate the average rate of return:

Step 1: Calculate the annual profit of a company:

$Average\mathit{}annual\mathit{}profit\mathit{}\mathit{=}\mathit{}\frac{\mathit{t}\mathit{o}\mathit{t}\mathit{a}\mathit{l}\mathit{}\mathit{p}\mathit{r}\mathit{o}\mathit{f}\mathit{i}\mathit{t}}{\mathit{n}\mathit{u}\mathit{m}\mathit{b}\mathit{e}\mathit{r}\mathit{}\mathit{o}\mathit{f}\mathit{}\mathit{y}\mathit{e}\mathit{a}\mathit{r}\mathit{s}}$

Step 2: Calculate the average rate of return of the investment:

$Average\mathit{}rate\mathit{}of\mathit{}rate\mathit{}\mathit{(}\mathit{\%}\mathit{)}\mathit{}\mathit{=}\mathit{}\frac{\mathit{A}\mathit{v}\mathit{e}\mathit{r}\mathit{a}\mathit{g}\mathit{e}\mathit{}\mathit{a}\mathit{n}\mathit{n}\mathit{u}\mathit{a}\mathit{l}\mathit{}\mathit{p}\mathit{r}\mathit{o}\mathit{f}\mathit{i}\mathit{t}}{\mathit{c}\mathit{o}\mathit{s}\mathit{t}\mathit{}\mathit{o}\mathit{f}\mathit{}\mathit{i}\mathit{n}\mathit{v}\mathit{e}\mathit{s}\mathit{t}\mathit{m}\mathit{e}\mathit{n}\mathit{t}}\mathit{}x\mathit{}\mathit{100}$

Basic Financial Terms: Break-even

To determine the point of break-even, we often use a break-even analysis. The break-even analysis calculates how many sales the company has to make to cover the fixed and variable costs of production.

Here's the formula for calculating the break-even point:

$\mathrm{Break}-\mathrm{even}\mathrm{point}=\frac{\mathrm{fixed}\mathrm{costs}}{(\mathrm{price}\mathrm{per}\mathrm{unit}-\mathrm{variable}\mathrm{costs}\mathrm{per}\mathrm{unit})}=\frac{\mathrm{fixed}\mathrm{costs}}{\mathrm{contribution}\mathrm{margin}\mathrm{per}\mathrm{unit}}$

A company with lower fixed costs will have a lower break-even point, assuming the variable costs do not exceed revenue.

Break-even graph

Figure 1. Break-even graph, StudySmarter

Looking at Figure 1:

• The break-even point is the intersection of the total cost and revenue.

• Loss is depicted below the break-even point (the space between revenue and the total cost line).

• Profit is depicted above the break-even point (the space between revenue and total cost line).

Margin of safety

Here's the formula for calculating the margin of safety:

$Margin\mathit{}of\mathit{}safety\mathit{}\mathit{=}\mathit{}Actual\mathit{}sales\mathit{}\mathit{-}\mathit{}Breakeven\mathit{}sales\mathit{}$

Financial statements

Financial statements are documents that give a picture of how well the company is doing financially. It includes three main documents: balance sheet, income statement, and cash flow statement.

Balance sheet

A balance sheet might include the following components:

Assets are what a company owns. There are fixed assets and current assets:

• Fixed assets are assets that will not be sold in the near future such as machinery, buildings, land, and equipment.

• Current assets are assets used in production or covering business immediate expenses. Some examples include cash, inventory, and accounts receivable.

Liabilities are what a company owes to others. They can be divided into short-term and long-term liabilities:

• Short-term (current) liabilities are debts that have to be paid back within a year. For example, accounts payable, overdrafts, dividends, etc.

• Long-term liabilities are debts that will be paid back over many years. For example, mortgages, bank loans, etc.

Equity represents ownership of a company. It is the deduction of liabilities from assets.

$Equity=Liabilities-Assets$

Here's an example of what a balance sheet might look like:

Figure 2. Balance sheet example, StudySmarter

Accounts receivable vs accounts payable in finance

Accounts receivable is the money that the customer owes to the company. It appears on the balance sheet under the current assets.

Accounts payable, on the other hand, is the money that the company owes to the supplier. It appears on the balance sheet under the current liabilities.

Both accounts receivable and accounts payable are money not yet paid.

Income statement

An example of an income statement:

Company A earned a total of £750,000 in the first quarter of 2022. Its gross profit is calculated as sales revenues minus the cost of sales, which was around £350,000. After deducting the overhead costs, taxes and interests, the company was left with a net profit of £180,000. This is the money it could reinvest into the business or distribute to the shareholders.

Cash flow statement

Unlike the balance sheet and income statement, the cash flow statement does not include non-cash transactions such as accounts receivable or depreciation.

Here's a simple version of a company's cash flow statement:

By keeping track of the cash flow, the company can assess its ability to pay off debts or convert non-cash assets into cash.

Now, let's have a look at the two ways companies can raise capital: equity financing and debt financing.

Equity financing

The type of financing with no repayment obligation is equity financing.

Equity financing does not require the company to repay the money it acquires. However, the owners need to give up part of their company's ownership to the investors.

Debt financing

A more common type of financing is debt financing.

When financed by debt, the owner does not need to give up part of the company's ownership. Also, once the debt is paid off, the relationship between the owner and the lender ends. The lender doesn't get to control the business.

The main drawback of this approach is that the company is liable to pay its debt along with interests.