Finance essentials to build a better business, part I

During the most recent economic downturn, Americans were reminded of an important and enduring lesson: small businesses (for our purposes, meaning any business doing less than $30M per year in revenue) are a critical – and the most resilient – part of our economic system. Yet, at the same time, the broader financial system is not designed to support small business growth and stability. Business success is deeply tied to financial health, and small businesses face a brutal confluence of factors that make financial health more difficult to manage:  

• They often lack dedicated finance teams, meaning that tasks like managing financial documentation, accessing capital and tracking payables and receivables often fall to the business owners. 
• Founders are less likely to be approved for financing, let alone financing at their desired amount. 
• Small business owners are also expected to extend a more significant amount of credit in the form of accounts receivable, meaning their provision of goods and services that are paid for at a later date.  

As an entrepreneur, your superpower might be the recipe behind the cookies, the tongue-in-cheek branding or the story you tell potential customers. That said, good entrepreneurship is also about wearing many hats, and one of them is understanding business finance. Every growing business needs the ability to navigate the intricacies of capital access and ultimately ensure it generates cash flows that can sustain the vision. In an environment where the odds are stacked against you, building your financial acumen is not a “nice-to-have” — it’s a requirement. After all, it’s the key to keeping your business healthy, capitalized and cashflow- positive. 

To help you get started as you build out your business’s financial roadmap, here’s a rundown of key finance terms and general guidelines to follow – important for any entrepreneur to understand as they start out their journey. 

I. Common Financial Terms 

There are hundreds of relevant financial terms, but here are a few that every entrepreneur should know: 

• Balance Sheet: A financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time.  
• Income (or Profit & Loss) Statement: A financial statement that shows a company’s revenues and expenses over a specific period, resulting in net income or loss. 
• Different types of margin:
  
  • Gross Margin: This is the percentage of money left from sales after paying the direct costs to make the product. 
  • Contribution Margin: This shows how much money from sales is left over after covering variable costs (costs that change with production volume) to help pay for fixed costs and profit. 
  • Net Margin: This measures how much profit a company makes from its sales after all expenses, including operational expenses, have been paid. 
  • EBITDA Margin: This shows how much profit a company makes from its total sales before interest, taxes and certain other costs are considered. 

• Different types of accounting (Note: We at Bags prefer small business clients to maintain both sets of accounting books): 

• • Cash Flow: This method records money when it actually moves in and out of the business. Revenue is recognized when received, and expenses are recognized when paid. 
  • Accrual: This method records revenue and expenses when they are earned or incurred, regardless of when the money is actually exchanged. This means recording sales when goods are delivered or services are performed, not when you get paid, and recording cost of goods sold at the transaction, rather than when you pay your supplier. 

• Debt Coverage Ratio: This is a measure that lenders use to determine how much money a business should be eligible for, as it shows how easily a business can pay its current or requested debts using its operating income. It compares the company’s earnings to the amount it owes or will owe, and most lenders seek at least a 1:1 debt coverage ratio (meaning the business currently makes a dollar for every dollar it owes or will owe each month). 
• Uniform Commercial Code Filings: A UCC filing is a legal notice a lender files when a loan is given to a business and the loan is secured by collateral. This filing is recorded with a designated state agency to publicize the lender’s right to potentially seize business property if the loan is not repaid, protecting the lender’s interest in the collateral.  

II. Topics to Consider

Now that you have some terminology down, here’s a quick list of concepts every small business owner should know. 

Interest Rate Adjustments 

Financial institutions typically use an interest rate benchmark when determining what they’ll charge for a business loan. The U.S. Federal Reserve makes regular rate adjustments, which influence how banks charge interest on financing. The most common benchmark is the Wall Street Journal Prime Rate, which affects business loans, mortgages and credit cards. When the WSJP goes up, it typically means higher interest rates on loans and credit products in the market. 

Merchant Cash Advances and “Two-Click Loans” 

The MCA has become a common alternative to a traditional loan due to ease of access and time to funding. In practice, though, these products are overwhelmingly predatory, coming with high costs, harmful terms and aggressive repayment schedules. Most business owners know better than to get a loan from a sketchy website, but more and more business services companies are offering MCAs to extract more value from their customers. These include e-commerce platforms, payments platforms and other tools we trust in our day-to-day business operations, which can make them attractive. At Bags, we like to say that there are two types of investment: fast money and good money. If it takes two clicks, it’s probably a bad deal. 

Financial Automation 

More and more, entrepreneurs can leverage AI and automation for business financial management. These tools are an awesome resource for general organization, data visibility and saved time, but they aren’t perfect. Fully automated solutions are likely to miss certain complexities of a business or let things fall through the cracks, and it’s important to have human oversight on tasks managed by an automated service. 

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About the author

William is a co-founder of Bags, leading the team’s client services and partnerships efforts. In his role, he is focused on bridging the gap between financial management and access to capital for every Bags customer, developing strategies and tools to help good businesses grow better. Prior to Bags, William helped build internal agencies and capabilities at IPG and advised executives at brands including American Express, Spotify, AT&T, Levi’s and USPS. His past work has been recognized with numerous awards, including People’s Telly Gold.