Many new entrepreneurs who are not finance professionals struggle with the jargon used in finance and accounts.
The objective of this piece is to acquaint recruitment entrepreneurs with the basic structure of finance and accounts required for a small business to start with.
Legal Structure of Business
As already explained in our previous article (The Recruitment Prerequisites | Getting Started), we recommend establishing a Limited Liability Company (a C Corporation) rather than a ‘proprietorship’.
Well, you can also start as a proprietary firm and then convert to a Limited Liability Company (LLC) later.
For the purpose of finance, your company will be treated as a separate legal entity, i.e. separate from the promoter (or shareholders).
Two Main Constructs in Finance
Balance Sheet: This is a statement of the assets and liabilities of a company on any given date. Assets are all that the company owns and liabilities are all that it owes.
As the name goes the assets and liabilities are always in balance (same). Let us understand this better. When an entrepreneur starts a company she can give the company money in two ways, as equity (money for shares- ownership) and as a loan ( also called debt).
Now, this is money that the company owes to the entrepreneur and therefore is classified as ‘Liabilities’. The company shall keep this money received as cash in its bank account and thus is classified as an ‘Asset’. (Refer to Table 1)
Table 1- Balance Sheet As of 01 May 2019
|Cash in Bank||13000||Equity||5000|
|Cash in Hand||2000||Debt(Unsecured)||10000|
If the company now buys a laptop for say 1000 dollars using cash in the bank, the above table will simply reduce cash in the bank to $12000 and add another row to the asset side, laptop (or computer or machinery) $1000.
However, if the payment for the laptop has not been made which means $1000 is payable to the laptop vendor then the balance sheet shall look like this- (Refer to table 2)
Table 2- Balance Sheet As of 05 May 2019
|Cash in Bank||13000||Equity||5000|
|Cash in hand||2000||Debt(Unsecured)||10000|
|Laptop||1000||Payables (to Vendor)||1000|
So repeating what we wrote earlier, anything the company owns is an asset and anything it owes is a liability. With this let us move to the other construct.
There is also the concept of Current assets/liability and long-term asset/liability. Current assets are assets that are liquid (like cash or cash deposits) which can be easily used. Assets that cannot be liquidated like machinery or a long-term investment etc are classified as long-term assets.
Similarly, liabilities that have to be paid within one year are termed as current liabilities and others like long-term debt are classified as long-term liabilities.
Profit & Loss Statement: Unlike the balance sheet with is a record of assets and liabilities on a given date, the profit and loss statement is computed for a specific period (Monthly, quarterly, yearly) and is a statement of revenues earned by the company and the expenses made(to earn that revenue). So if you have billed a total of $40000 for five placements in a particular month and have one employee and some regular expenses then your profit and loss statement will look like this-
Profit & Loss Statement for the Month of May 2019
(Expense) in $
|Interest Earned (On bank deposit)||50|
|Software & Internet Expense||(1000)|
|Depreciation (Furniture & Computers)||(200)|
Well, the above is only an indicative statement and will be volatile depending on your revenues earned (expenses other than commissions are more or less stable). The Profit and loss statement is of course linked to the balance sheet. So for example, if you have billed your client $40000 and they have paid you one invoice let’s say $15000.
Then this cash collected $15000 will add to cash in the bank on the Asset side of the balance sheet and the remaining $25000 will also reflect in another row as receivables (asset).
Similarly, if you were to pay a rent of $3000 for May 2019 but have not yet paid this then the liability side of the balance sheet will reflect a row of ‘Rent Payable’ $3000.
For Making a Profit & Loss Statement, There Are 2 Methods
1. Cash Basis: So, in the above example, you fill the revenue column with $40000 only if the cash has been received in your bank. Else the revenue will be zero. The same goes for expenditure. So, if an employee has earned a commission but it is not paid yet then it is not counted as expenditure till such time it is not paid.
2. Accrual Basis: Accrual basis accounting is what is normally adopted and any revenue earned (though not received) or an expense accrued ( though not yet paid) is accounted for in the profit and loss statement.
It would also be a good idea for the business to subscribe to some basic accounting software. Using an accounting tool like Xero, QuickBooks, etc. you can easily file VAT returns and manage all the other business taxes online. There would be many in each country and can be easily found online. Most of them sell on a per-user basis and cost between $10 – $30 per month per user. You can always seek an accountant’s help for the initial set-up. Most software has in-built integrations and can be connected with your business bank accounts and instant approval credit cards. It helps you to keep a track of all receipts and expenses once set up, all you need to learn is to-
- Create & edit an invoice
- Enter receipt of payment
- Enter expense in the system (and learn to categorize the expense)
That much is good enough and then you can again seek
any accountants help to file your business tax returns at the end of the year.
Some Important Finance Terms/Concepts
- Depreciation Whenever you purchase an asset (any equipment, be it a computer, furniture, mobile, etc), the entry is made in the asset side of the balance sheet and with a corresponding reduction in cash on the same side. You basically convert your cash(asset) into a computer(asset).
- Now we all know that a computer will be used for let’s say five years. So if you have purchased a computer for $1000 then, you are basically using up to $200 per year. So at the end of the year, you will depreciate the computer to $800 and add the $200 as depreciation expense in your profit and loss account for the year.
- Of course, there are various formulas and rules for depreciation by the tax authorities for different items of machinery and you can leave that for your accounting consultant to figure out. It is important that you understand the concept.
- Amortization A concept similar to depreciation though used for items like the software (which actually does not depreciate) so that the upfront cost of the software can be apportioned to multiple years as you would use the software for many years. Though nowadays with the SAAS (software as a service) model and monthly and yearly subscription, it is becoming less relevant.
- PBT This is just a calculation of profit before tax and is self-explanatory
- PAT This profit after tax is also known as Net Income.
- EBIDTA This is revenue less all expenses other than Interest Expense, Depreciation, tax, and amortization (Therefore Earnings Before Interest Depreciation Tax and Amortization).
- Working Capital Every company will always require some ready capital for its regular payments/functioning. This requirement is typically a simple formula of current assets minus the current liability.
Understanding Business Financing
As mentioned earlier a company may be financed using equity (value of shares – Ownership) or using debt (Loan either from the owner or bank or anyone else).
The cost of debt is very simple. It is the interest cost of the capital. It may range from 5% to 15 % or more depending on the economy in which you are operating. It will also depend on whether the debt is secured(where some asset like a house or property is pledged against it) or unsecured.
Obviously secured debts are cheaper. One this to understand is that because the interest paid on a company debt is categorized as a business expense the net interest paid is lesser than what you actually pay a bank.
For example, if the company has taken a loan(debt) of say $200000 and pays an annual interest of 10 % ( ie $20000).
Now if the company was making a profit of $60000 for the year and let us say the corporate tax rate is 20%, then the company would have paid $ 12000 as tax. However, now that there is an interest expense of $20000 incurred, the profit only shows as $ 40000 and therefore actual tax paid is $8000. The company has saved $ 4000 on taxes.
Another way of looking at it is that the interest paid
is only $16000 (ie $20000 to be paid as interest minus the $4000 saved in taxes). Therefore an interest rate of 8% and not 10 %.
Now let us look at the cost of equity. It is important to understand that the two equity is more expensive by a large margin. Now imagine your company is making a profit of $60000 per year and instead of taking debt you have given equity worth $200000.
Now the good thing about giving equity (ownership shares) is that this money need not be returned. So the person buying the equity is assuming the risk that the company goes bust.
Let us assume the company is valued at 20 times profit so your company is worth 1.2 million dollars. Now if you raise equity worth two hundred thousand dollars you will need to part with 14.28 % of equity ( ie 200000 / (1200000 + 200000)). At such a small size of an organization, it is not very difficult to grow around 50 % in a year.
So now if in the next year your company makes $90000 profit it would be valued at 1.8 million dollars (20 times annual profit). Now the value of the 14.28 % of equity is $257040. So the $200000 has grown by 28.5 %. So the cost of equity is 28.5 %.
Much as I have made simplistic assumptions I hope the concept is understood. Therefore an entrepreneur must be very careful while giving away equity especially so at the early stage of the start-up.
It could turn out to be very expensive (imagine if the company had grown by 100% or more)
Though I have written this for recruitment entrepreneurs the article is relevant to any small business/start-up. The few topics and jargon covered are enough for a non-finance background entrepreneur to get started.