16 Basic Business Terms You Must Know
To those starting out in a new business or industry, it may seem that everyone is speaking a different language — people are balancing sheets, turning over inventory, and analyzing costs both fixed and variable.
These are basic terms in the business world and yes, ones that you’ll need to know in order to understand what’s going on and communicate effectively.
You’ll deal with these 16 basic business terms quite often. We’ll help you learn exactly what they’re used for, and before you know it, you’ll be using them fluently on a regular basis.
This article rounds up the most important, commonly used phrases you’ll hear when doing business, and serves as a quick reference for whenever you’re at a loss for words.
Company Assets Terms
Assets are any item of value owned by the company and therefore, a clear sign of whether the company is doing well or not. The following basic business terms and formulas are used to determine whether a company has enough of these assets to keep it afloat in the near future.
Working Capital (or Net Working Capital)
This is the available cash a company has for its daily operations. Working capital is important — especially to investors — as it measures a company’s liquidity, operational efficiency, and overall financial health.
It is calculated as a company’s current assets (cash, inventory, accounts receivables) minus its current liabilities (rent, wages, business loans, accounts payable).
If the current assets are greater than the liabilities, the company has positive working capital and is able to invest and grow. If the current assets are less than the liabilities, however, the company has what’s called a working capital deficit and may not have enough cash on hand to pay operating expenses.
Working Capital Formula (or Net Working Capital Formula)
The basic working capital formula is:
Working Capital = Current Assets – Current Liabilities
For example, if your current assets are $100,000 and your current liabilities are $50,000, your working capital is $50,000. Keep in mind that “current” usually refers to short-term assets and short-term liabilities — anything available within 12 months.
Working Capital Ratio (or Current Ratio Formula)
This is another, more comparable way to calculate a company’s working capital. Use this formula:
Working Capital Ratio = Current Assets / Current Liabilities
Using the above example of current assets worth $100,000 and current liabilities at $50,000, working capital ratio is 2.0.
A working capital ratio of 1.0 indicates the current assets and liabilities are equal, while a ratio of 2.0 means the company has twice the value of assets as it does liabilities. Depending on the industry and the analyst you ask, a ratio between 1.1 and 2.0 is a good indicator of financial health.
This financial ratio compares a company’s total debt to its total assets, specifying what percentage of a company’s assets are financed by debt. It also indicates the extent of a company’s financial leverage. The lower the company’s debt ratio, the less leverage the company is using and the stronger its equity position. The higher the debt ratio, the more leverage the company is using and therefore, the more risk they have taken on.
The formula is:
Debt Ratio = Total Liabilities / Total Assets
Take note that you need the total current liabilities and total current assets, as this formula indicates overall long-term debt, rather than a company’s short-term debt. For example, a company with $50,000 in total liabilities and $500,000 in total assets would have a debt ratio of 0.1.
Lower ratios imply lower overall debt and a more stable business, while a ratio of 1.0 means the company’s total debt equals their total assets. Anything greater than 1.0 indicates most of the company’s assets are financed through debt.
To be fair, ratio analysis varies widely across industries — a capital-intensive business will tend to have a higher debt ratio as compared to, say a lean startup in the technology sector. But in general, a reasonable ratio would be about 0.5.
Financial Performance Measurement Terms
Finances — or more accurately, the finances a company has on hand — are a good measure of how well it’s currently performing. Basic business terms like EBIT and EBITDA provide precise ways to calculate how the company is doing.
EBIT (Earnings Before Interest and Taxes)
EBIT is a measure of a company’s operating performance and profitability, calculated as revenue minus expenses (excluding tax rates and interest payments). Also referred to as operating profit or operating earnings, EBIT is used to analyze a company’s earning and profitability from pure operational performance. It estimates the company’s overall cash flow, and is one of the last subtotals before calculating for net income.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
EBITDA is another measure of a company’s performance and profitability, which is calculated similarly to the EBIT formula, but adds another step by putting depreciation and amortization expenses back into the company’s profit.
Use EBITDA for analyzing companies that are capital-intensive or have large amounts of amortizable intangible assets, as these can overwhelm their net income and give the appearance of a significant loss.
EBITDA is a somewhat controversial metric (Warren Buffett isn’t a fan), as it is an adjusted figure that results in different profit numbers, But it is useful for measuring the cash flow of a company, and valuing it for acquisition purposes.
Costs and Operations Terms
Every time a company produces something, whether a good or service, it incurs costs. This next set of basic business terms help to classify these costs and compare them against overall profit.
Commonly referred to as overhead costs, fixed costs are company expenses that do not vary with production or amount of goods or services sold. They remain the same no matter what the sales numbers are, and therefore can’t be avoided.
Fixed costs tend to be time-related (i.e., monthly rent, utilities, insurance premiums), and while they do change over time, they are considered “fixed” for the relevant production period.
Variable costs are company expenses that change in proportion with the amount of goods or services produced, such as raw materials, packaging, and sales commission. These decrease or increase depending on production. If production volume decreases for one month, so will variable costs. If production volume increases the next month, so will variable costs.
Here’s the general formula:
Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output
The break-even analysis determines at what specific point a company “breaks even,” neither losing nor making money. You can also look at it as how much a company needs to sell to cover total costs. Performing a break-even analysis is important as it determines when a company can expect to start generating profit. It’s especially useful for starting businesses, for launching a new good or service, or before implementing a new business strategy.
Here’s the formula:
Break-Even Analysis = Fixed Costs / (Unit Selling Price – Variable Costs)
For example, if a company’s fixed costs are $50,000, its unit selling price is $50, and its variable costs are $25, then it needs to sell 2,000 units to break even.
The divisor in the formula (unit selling price minus variable cost) is also referred to as a contribution margin, which is the amount each sold unit contributes towards covering fixed costs and increasing profit. In this example, the contribution margin is $25. So once the break-even point is reached, each additional sale will increase profits by the contribution margin of $25.
The inventory turnover is how many times a company has sold and replenished their inventory during a certain time period. This number helps companies understand which products are sellable, what price range is attractive, and which marketing efforts are effective.
The calculation for is:
Inventory Turnover = Total Sales / Average Inventory
In this calculation, the average inventory is the beginning inventory plus ending inventory, then divided in half. For example, if a company has sales of $150,000 and an average inventory of $50,000, the inventory turnover rate would be 3 — meaning that they sold their inventory three times during the period.
You can then divide the days in the period by the inventory turnover formula to calculate the number of days it takes to sell the entire inventory on hand. These numbers will give you a better idea of your inventory levels, how much inventory to produce, and how to begin organizing a more efficient turnover.
Once costs have been calculated, they can be used to figure out a company’s earnings, or profit. These earnings-related basic business terms are important indicators as to whether the company should continue its current operations or reevaluate its finances.
Gross Profit (or Gross Margin)
The gross profit is the net sales a company makes after it covers all the costs required to make a sale, also known as the cost of goods sold (COGS). COGS is the total of both fixed and variable expenses, including everything from rent and salaries to materials, shipping, and delivery. With these in mind, the gross profit is the profit after cost of goods sold, but before subtracting interest rates and taxes.
The formula is:
Gross Profit = Sales – Cost of Goods Sold
For example, if a company sells $500 and has a COGS of $200 for a certain time period, their gross profit is $300.
Gross Profit Margin
This measures profitability by showing the percentage of revenue that exceeds the COGS. The formula to calculate it is:
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
Using the example from above, the gross profit margin of the company would be 0.6 or 60%.
The gross profit margin is important because it shows how efficient a company is at creating and selling a good or service. The higher the percentage, the more a company earns in relation to its expenses.
Net Margin (or Net Profit Margin)
This is the percentage of profit a company retains from its total revenue, after total expenses have been deducted. Also known as net income, it measures the overall profitability of the company.
The formula to calculate it is:
Net Profit Margin = (Net Profit / Net Sales) * 100
For example, if a company has a net profit of $200,000 and a net sales of $500,000, its net profit margin would be 40%. Although the industry average varies widely, anything in excess of 10% is considered good, and anything higher is obviously better.
Financial Statement Terms
Learn this next set of basic business terms to understand financial statements, where it all comes together. Once all the formulas and figures are inputted into the following sheets, a company’s health and performance can be accurately measured.
Income Statement (or Profit and Loss Statement)
An income statement is one of three of a major company’s financial statements used by accountants and business owners (the other two are noted below). Also referred to as a profit and loss statement (P&L statement) or statement of operations, this shows a company’s profitability or net revenue.
The income statement focuses on revenues, expenses, gains, and losses during a specific period of time indicated on the statement heading. It does not cover any cash receipts or cash expenses.
Although there are many income statement variations, it usually begins with sales, then deducts the expenses to reach the net income, and finally ends with the earnings per share. General line items include sales revenue, COGS, depreciation and amortization expense, and tax expense.
This is another key financial statement, and is best described as a snapshot of a company’s financials at a particular date. Also referred to as a statement of net worth or statement of financial position, the balance sheet displays total current assets and how the assets are financed (either debt or owner’s equity).
Based on the basic equation of Assets = Liabilities + Equity, the company’s balance sheet is divided into two sides — the left outlines all a company’s assets, while the right lists all its liabilities and shareholders’ equity. All the items are usually classified by liquidity, with cash and payables placed before land, buildings, and equipment. Each side is duly filled up and totalled at the bottom for a final balance.
Since a balance sheet provides a static financial position of the company, it’s best to use this alongside the more dynamic income statement and cash flow statement for a fuller picture of a company’s position.
Cash Flow Statement
The final of the three financial statements, the cash flow statement reports all cash earned and spent during a specific time period. It’s the bridge between the income statement and balance sheet as it shows how money moves in and out of the business.
The three sections of the cash flow statement comprise all the ways a company manages its cash, including operating activities (how it generates revenue), investing activities (what assets it invests in), and financing activities (how it pays back debts and shareholders).
The cash flow statement reflects a company’s financial health and helps predict future operating cash flow. It helps gives investors a clear picture of a company’s ability to generate cash and invest it back towards growth.
Getting Down to Business
Learning basic business terms takes time and practice. Although these terms may seem like quite a mouthful at first, they will get easier as you go along (we promise!). Start with the terms that are most useful to you, and continue to add on more as you learn the ins and outs of business.