Glossary of Financial Terms and Meanings

Understanding Financial Terms and their Meaning In Business

To help SME owners understand more about the terms that appear on their Profit & Loss and Balance Sheet reports, either from their own accounting systems or from their accountants reports, here are a number of words used in business finance world-wide, everywhere in businesses small, medium and large, in private companies and public companies and in government.

Each of these words and terms has the same individual meaning when people use them to discuss the financial performance of a business – for example, when we talk about sales or income or revenue – these words all mean, the money (dollar value) a company generates when it completes a sale for the products or services it delivers to its customers.

Below is a glossary of the financial words and terms you will need to become familiar with to understand the text and work the exercises in the programme.  Use the next two pages as your dictionary of financial terms for your studies.

The first terms are to be found in the company’s Profit & Loss statement.

The profit & loss statement is a report which shows how a business has performed financially on paper over a set period, and records all the costs, expenses and sales dollar figures, set out in a format commonly used by all accountants and business managers.

The Profit and Loss Statement and its Terms

Term   Definition   Example  

Sales, Income, Revenue

 

The total recorded value of all the selling transactions for a particular period.

 

$1,000,000

 

Cost of Goods Sold (COGS) OR,  Cost of Sales

 
 

The absolute total cost of the product or service incurred to be able to supply the item to your customer.  COGS usually includes the delivered cost of raw materials used to make products, direct labour involved in production, any special costs that relate directly to making the products, such as protective clothing or special processes or subcontract costs. Services don’t really have a cost of “goods”.

 

$550,000

 

Gross Profit

 

The remains of the sales income after the cost of goods has been taken away.  This is often termed “the first real income of a business” as you must have “costs of goods” to make products available.

 

$450,000

 

Gross Margin

 

This is an important term which is used in all businesses to compare profit performance from period to period, or from business to business, or industry to industry.

To simply say that a company made $100,000 gross profit doesn’t tell us how good a profit that really is.  We need the Gross Margin figure! 

To calculate Gross Margin, we divide the Gross Profit dollars by the Sales dollars to get a RATIO called the Gross Margin.

A business can lose Gross Margin by having sales drop, or having higher COGS – both are equally damaging to this important figure

 

$ 450,000

divided by

$1,000,000

equals

45% GM

 

 

Expenses

 

Expenses in a business are all the running costs, other than those directly related to the actual production cost of the goods made for sale.

Expenses cover costs such as rent, advertising, bank charges, administration wages, sales commissions , computer system charges, training, accounting fees, electricity, rates, company vehicles, factory repairs and maintenance.  All these items are explained in first lesson in this course.  It is absolutely vital that good control of expenses is maintained in every business, because as you will see, if expenses are greater than Gross Profit there is no bottom-line profit or Net Profit.

 

$320,000

 

Net Profit Before Tax

 

This is the most common measure of how successfully a company is actually ‘running’ its business.  The objective of being in business is to produce a Net Profit.  This is the money left from Sales after ALL costs have been allocated (not necessarily paid).  It is not what is in the bank account – this is covered in the lesson on cash-flow.

The Net Profit reported is the money left before the company pays its income (company) tax, which is 30 cents in every dollar of reported profit (or a tax rate of 30 %).

Because all Australian companies pay the same rate, and many companies have tax credits from other activities, it is the Net Profit Before Tax (NPBT) that is the most frequently used to measure and compare profitability performance in company reports.

The NPBT is also a figure that is converted to a RATIO, because it is easier and more meaningful to compare profit performance from period to period, or from business to business, or industry to industry by using this ratio rather than straight dollars.

The calculation is the same as for Gross Margin and answer is called the Profit Margin.

 

$130,000

divided by

$1,000,000

equals

13% NP

 

 

The Balance Sheet and its Terms

While the Profit & Loss statement is record of financial activity in a business, the Balance Sheet is a summary, usually done annually, which provides a picture of where the money in a business, and how much of it, has been used.

A business uses Assets to create income and wealth.  Income and wealth are different – income is the money that comes in and wealth is the end result of using the income wisely.  For example, we all have an annual income (salary or wages), on which we pay tax.  The tax paid remainder is what we live on and pay off the mortgage or pay rent.  If you are paying off a mortgage you are building up an Asset (which is wealth), if you are paying rent you are not creating an asset.

Companies face the same type of problems.  They can use all their money (income) to live (i.e. run the company) or spend on, say, advertising or wages or rent.  Wise and well run companies build the value of their assets.

A business also creates Liabilities in the normal course of trading.  Liabilities are financial items which are owed to external parties by the business.  For example, a bank loan or an overdraft at the bank, are liabilities.  Money owed to creditors, for materials and supplies are liabilities until paid.  Hire purchase payments or lease payments for equipment or vehicles are liabilities.

 Thus, we can say that the Balance Sheet is record and a result of where a company has spent the profit it has generated over the financial year.  It is called a Balance Sheet because the Asset on one side of the sheet should be equal to (or greater than) the Liabilities.  The difference between the two, called Net Assets is the actual NET WORTH of the company or the Owner’s Equity.

The objective of every business is to work to have the Assets side greater (and growing) compare to the Liability side, thus increasing Equity.

Term   Definition   Example  

Current Assets

 

Those assets which can be converted into cash at short notice, say within 12 months.  These assets are the negotiable assets of the business and include debtors (people who owe the company money for goods or services provided), cash at the bank,  inventory (stock),  investments

 

$175,000

 

Non-Current Assets
(Fixed Assets)

 

 

The higher value assets used in generating the income of the company and includes factory plant and equipment, office furniture and equipment, motor vehicles, property, goodwill.

 

$317,000

 

Total Assets

 

The total of all Assets

 

$492,000

 

Current Liabilities

 

Those liabilities that can or should be able to be paid within a short period, normally within 12 months.  These include the bank over-draft, short term loans, creditors, GST, owner’s loans on call (i.e. cash drawings not taken)

 

$97,400

 

 

Non-Current Liabilities
(Fixed Liabilities)

 

Longer term, higher value liabilities such as vehicle and equipment leases, large capital loans, property mortgages.  These liabilities are often financing the company’s operations, above the company’s profit capacity.

 

$268,600

 

 

Total Liabilities

 

The Total of all Liabilities.

 

$366,000

 

Net Assets or Net Worth or owner’s Equity

 

The difference between Total Assets and Total Liabilities

 

$126,000

 

Working Capital

 

The money required AND available to run the business.

Calculated as CURRENT ASSETS minus CURRENT LIABILITIES

 

$77,600

 

 

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