A Beginner’s Guide to Financial Literacy for Small Business Owners
Most of the top causes of small business failure involve financial errors: insufficient initial funding, rampant cash flow problems, poor financial planning, inadequate market size, etc. Therefore, to build a small business that will last, you must have advanced financial literacy to keep your company afloat.
Being capable of managing your wealth is one thing; having the financial expertise to build a strong and stable small business is quite another. Here is a beginner’s guide to small business financial literacy to gain the knowledge and skills to make your entrepreneurial dreams come true.
What Financially Literate Small Business Owners Can Do
Financial literacy is arguably the most critical skill for small business owners, as it is essential in managing some of the most vital tasks of building and maintaining a business. Those tasks include:
Manage Cash Flow
Cash flow covers all of a business’s incoming and outgoing money. Managing cash flow matters because businesses always need enough liquid assets to cover their expenses; in other words, business leaders need to understand their top line vs. their bottom line, or they may be unable to afford the resources essential for operation. Cash flow problems are consistently among the leading causes of small business failure, so it pays to be financially literate for this ability alone.
Handle Taxes
Many different types of taxes apply to small businesses. While small business owners could outsource tax preparation to a third party, the ability to manage this financial task yourself could save you money and keep the rest of your finances in proper order.
Analyze Financial Statements
Perhaps the most valuable ability granted by financial literacy is understanding financial statements. The documents listed below contain important information that savvy business owners can use to make better business decisions.
Basic Financial Documents for Small Businesses
If you invest in no other financial skills, you should at least familiarize yourself with basic financial documents, which will be essential for understanding, organizing, and growing your small business. Every small business utilizes the following financial documents:
Profit and Loss Statements, also called income statements or statements of operations, show a business’s revenue accrual, how expenses account for that revenue, and whether the company turned a profit over a specific period.
Cash Flow Statements. These statements offer a detailed look at the cash flowing in and out of an organization. Unlike a P&L, a cash flow statement focuses on liquid assets (primarily cash) gained and lost over a specific period.
Balance Sheets detail a company’s assets, equity, liabilities, and other elements typically not covered on P&L statements. Balance sheets often highlight what a company owns and what it owes, which can help business leaders make leveraging decisions.
Break-even Analyses. The break-even point is when cost and revenue are equal — which is not usually the goal for businesses. Still, break-even analysis can help leaders determine how much money they can spend and how much revenue they will need before reaching profitability.
Business Ratios. Ratios are essential tools in business finance because they make it easy to understand complex information. Some common ratios small business owners are likely to benefit from include:
- Net Profit Margin ratio: net profit after taxes / net sales
- Gross Profit Margin ratio: (revenue – cost of goods sold) / Revenue
- Profit margin ratio: (revenue – expenses) / revenue
- Quick ratio: (cash + marketable securities + accounts receivable) / current liabilities OR (current assets – inventory) / current liabilities
- Return on investment ratio: (gain from investment – cost of investment) / cost of investment
- Current ratio: current assets / current liabilities
- Standard size ratio: line item/total
It is tempting to assume that you will be able to learn the financial processes involved in small business ownership as you build your business. Still, the truth is that too much of your business success hinges on your ability to manage your finances effectively from the start. By putting time and effort into gaining greater financial literacy, you will reap the rewards of a small business that survives and thrives.
