Top 10 Finance Terms Before getting financing, make sure to familiarize yourself with the basic terminology.
By David Newton
Opinions expressed by Entrepreneur contributors are their own.
There are a few basic finance terms that every entrepreneurshould fully understand. They represent the core of understandinghow business development works across all stages in the life of aventure, so it's important you understand their meaning.Here's a quick review of the terms you need to know:
1. Return on investment (ROI): The only way to thinkabout your business is with an ROI perspective. The entrepreneurhas committed capital investment into a certain combination ofassets, from which the company generates sales. Those sales coverthe costs of operations and hopefully produce a profit. Thatprofit, divided by the total funds invested in the company (theassets), equals the ROI to the entrepreneur. Think of it this way:Would you work all those hours and take on all that responsibilityif your ROI was only 6 percent annually? The stronger the profitpicture compared to the total funds employed in the enterprise, thehigher the ROI.
2. Internal rate of return (IRR): Every decision enactedby the entrepreneur must be viewed in terms of its internallygenerated return to the company. Unlike the simple division used tofind the ROI, the IRR compares the net expected returns over theuseful life of a project being reviewed by management to the fundsspent on that decision (or project). All projects must meet acertain IRR in order to be acceptable for investment by thecompany. If a project cannot meet a minimum IRR, then don'tinvest in it.
3. Fixed asset base: This is the long-term base of thecompany's operation strategy, represented by all the equipment,machinery, vehicles, facilities, IT infrastructure and long-termcontracts the firm has invested in to conduct business. From afinance perspective, these assets are the revenue generators. Whenthe entrepreneur decides to invest in a certain fixed assetconfiguration, that becomes the base from which the companyfunctions week in and week out, doing business and servicing itscustomers.
4. Working capital: Current assets are those short-termfunds represented by cash in the bank, funds parked in near-terminstruments earning interest, funds tied up in inventory, and allthose accounts receivable waiting to be collected. Subtracting thecompany's current liabilities from these current assets showshow much working capital (your firm's truest measure ofliquidity) is on hand and its ability to pay for decisions in theshort-term. For example, if the firm has $500,000 in current assetsand $350,000 in current liabilities, then $150,000 is free andclear as working capital, available for spending on new things asneeded by the company.
5. Cost of capital: This is the true cost of securing thefunds that the business uses to pay for its asset base. Some fundsare from debt (less risky to the creditors, so it has a lower costof capital to the firm), and some funds come from equity (morerisky to the investors, so these have a higher cost of capital).The combination of lower-cost debt capital with higher-cost equitycapital produces the next item in this list.
6. Weighted average (between debt and equity) cost of capital(WACC): This is the firm's true annual cost to obtain andhold onto the combination of debt and equity that pays for thefixed asset base. Every time the owners contemplate investing in anew project, the IRR for that project must be at least equal to theWACC of the funds used to do that project, otherwise it makes nosense taking on that new project, because its return cannot evencover the cost of the capital employed to make the projecthappen.
7. Risk premium: Entrepreneurs must understand that everydecision they consider has an inherent level of risk associatedwith it. If project A is far riskier than project B, there shouldbe a clear risk premium that could accrue to the firm if project Ais enacted. But with that risk premium return, there will also be arisk premium cost to the company for the use of the funds. Businessowners always have to decide whether the risk premium of additionalpotential return is commensurate with the additional risk coststhat come with doing that investment project.
8. Systematic risk: Some risks facing the company are notunique to that business in that market, but are faced by all firmsoperating in the broader, general marketplace. These so-called"systematic" risks (such as changes in interest ratelevels, the performance and direction of the U.S. economy or theavailability of certain types of skilled labor) cannot beavoided.
9. Nonsystematic risk: The risks that are entirely uniqueto your company, products, buyers, promotional programs, billing,pricing, IT system and so on are nonsystematic risks specific toyour firm. Although there's little you can do to avoid ormitigate exposure to systematic risk, it is possible to use variousdiversification strategies to offset risks that are unique to yourbusiness. When working with risk premium, systematic risk andnonsystematic risk, the rule is that the expected return on thebusiness operations will always be directly related to the amountof risk taken on: Lower risk decisions come with lower expectedreturns, and higher risk decisions come with higher expectedreturns.
10. Option premium: A "call" is an option tobuy something at a future date; a "put" is an option tosell something at a future date. On virtually every partnershipcontract, vendor deal, distributor arrangement, equipment lease orfinancing, personnel hire and investment decision, there willlikely be some kind of option offered to one party by the other.Entrepreneurs must always place a dollar value on any optionpremium they offer or have offered to them in these various deals.The value of having an option to either buy or sell, agree ordisagree, accept certain terms or let them expire, should always bedetermined prior to signing any deal or contract or term sheet, andthat value should always be treated as a tangible benefit whennegotiating decisions with parties inside and outside the firm.
David Newton is a professor of entrepreneurial finance andhead of the entrepreneurship program, which he founded in 1990, atWestmont College in Santa Barbara, California. The author of fourbooks on both entrepreneurship and finance investments, David wasformerly a contributing editor on growth capital for IndustryWeek Growing Companies magazine and has contributed to suchpublications as Entrepreneur, Your Money,Success, Red Herring, Business Week, Inc.and Solutions. He's also consulted to nearly 100emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column arethose of the author, not of Entrepreneur.com. All answers areintended to be general in nature, without regard to specificgeographical areas or circumstances, and should only be relied uponafter consulting an appropriate expert, such as an attorney oraccountant.
