What Are The 7 Steps To Understand Finance For Your Business

7 Steps To Understanding Business Finance 

1. Understand Profit Vs Revenue 

If you’re a complete beginner to business finance, one of the first things you’ll need to understand is the difference between profit and revenue. 

Both revenue and profit can be loosely described as ‘how much money you make’, but there’s a crucial difference. 

Revenue is the total amount of money your business brings in over a period of time. For example, if you sell $1,030 worth of products over a month, then your revenue for that month is $1,030. Simple, right?

What’s not quite so simple is calculating profit. Profit is not the same as revenue because it takes into account your expenses. When calculating profit, your expenses are subtracted from your revenue.

For example, if your business brought in $1,030 from sales, as above, but the other costs of running your business during that month totalled $740, your profit would only be $290. 

This is a very simple way of putting it, and when you do these calculations in real life, you’ll need to know the difference between net profit and gross profit, which we’ll get into in a moment.

However, before we do, there’s another element of business finance you need to get to grips with. 

2. Learn To Calculate Cost Of Goods Sold 

Your Cost of Good Sold, known as COGS, refers to the amount of money it costs you to make and deliver your products or provide your services to clients. 

That includes the cost of materials and direct employee labor. Bear in mind that indirect labor isn’t included in this calculation.

For example, if you have a fashion business, the labor costs of the employees actually making the garments will be factored into your COGS, but the marketing costs to promote the garments won’t be included. 

Finding out your COGS for individual products and services is really important because you will need this information to calculate your gross and net profit, which is the next thing you need to understand about business finance.

3. Figure Out Gross Vs Net Profit 

There are actually two different types of profit you need to know about if you’re running a business. The first is gross profit, and the second is net profit. 

Gross profit is calculated by subtracting your COGS from your revenue. Remember, your revenue is the total amount of money your business has made without any expenses deducted as of yet.

So, returning to our example above, if your revenue for the month is $1,030 but your COGS is $616, then your gross profit is $414. 

If you want to know your net profit, however, you need to subtract all other expenses from your gross profit.

You’ve already subtracted the COGS from the revenue to get the gross profit, so now you need to take away from the gross profit any expenses that aren’t material costs or direct labor costs. 

For example, this is where you’d subtract any marketing costs, the monthly rent for your office (assuming you have one) and any other expenses that go into keeping your business afloat. 

Say your gross profit is $414, and you paid $124 for marketing. Then, the rent for your very small office space is $500.

In this case, your net profit wouldn’t be a profit at all, since you would have made -$210 that month. So, you can see how important it is to know the difference between gross profit and net profit. 

4. Find Your Gross Margin 

Besides calculating your gross profit, you’ll also need your COGS figures to understand what your gross margin is. 

Your gross margin basically allows you to see your profit per dollar as a percentage. This is based on your gross profit, not your net profit, so you start by subtracting your COGS from your revenue. 

Let’s say the sum of your revenue ($1,030) minus COGS ($616) is $414. That’s your gross profit. Then, you need to do the following sum: 414/1,030 = 0.402. 0.402 x 100 = 40.2. Therefore, your gross profit margin, also known as net sales, is 40.2%. 

So, for example, if you made $1,040 in net profit (NOT gross profit) this month, but your business expenses (as a whole, not just COGS) came to $1,532, you would need to sit down and work out how you’re going to either cut back on expenses or increase sales to even out your cash flow or, hopefully, make it positive.

6. Income Statements And Balance Sheets 

There are two main kinds of financial documents you’ll need to keep an eye on if you want to monitor your business finances. These are income statements and balance sheets. 

An income statement can also be called a profit and loss statement. This document is usually drawn up on a monthly basis, but it’s sometimes done quarterly. 

The point of an income statement is to calculate your income and your expenses to show you your net profit (or lack thereof) for the given period. 

On the other hand, a balance sheet is a bit more detailed because it includes business assets and liabilities. 

Basically, in the same way as your gross profit takes into consideration your COGS but not other expenses, while your net profit is a more considered calculation, your balance sheet goes into more detail and gives you a more realistic picture of your finances than your income statement. 

You need both of these documents to truly have an idea of your business’s financial status. 

7. Account Tracking (Payable And Receivable)

When you start getting serious about your business’s finances, you’ll hear about two types of accounts: ‘accounts receivable’ and ‘accounts payable’. 

This is the financially literate way of differentiating between money that you owe to creditors and money that is owed to you (that is, your business). 

Your accounts payable might include delivery services or rent, while your accounts receivable could involve clients’ monthly memberships. 

It’s important that you make sure you’re receiving payments on time as well as making payments on time.

You don’t want to fall behind with your creditors, and you also don’t want to be going without money you’re owed for a long period of time, so staying on top of your accounts, both payable and receivable, is crucial. 

Frequently Asked Questions 

How Do I Become Good At Finance?

If you’re already involved in running a business, the good news is that you’ll learn about finance pretty quickly because it will be part of your daily life. 

However, if you want to boost your knowledge, you should take some accounting classes and focus on learning data analysis and forecasting.

We also recommend practicing your budgeting skills as much as possible in your personal life since this is a skill that translates well to business situations. 

How Do I Organize My Business Finances?

Getting the right kind of accounting system and making sure you have a separate bank account for personal and business finances is essential to keep your business finances organized. 

Once you have done this and familiarize yourself with the areas of finance outlined in this article, your finances should fall into place. However, if your business finances are a real mess, it’s a good idea to speak with a financial advisor.

Do I Need To Understand Finance To Run A Business?

To open your own business, large or small, you need to either have a very solid understanding of business finance or hire someone who can organize your finances for you. 

However, it’s generally not a good idea to rely entirely on someone else’s knowledge for your business decisions, so we recommend learning as much about business finance as possible before opening a business.

Final Thoughts 

Understanding business finance can seem like a daunting task, but as long as you focus on the 7 areas outlined in this guide to begin with, you’ll quickly make progress with your financial knowledge.