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Financial Literacy Basics for Young Entrepreneurs – part 1

Financial literacy is essential to business acumen. In order to see the big picture, you have to understand every aspect of the company’s finances. Fortunately, anyone can improve financial literacy with some basic instruction and practice.

Assets

Assets are anything of value that the company has that will create a profit or improve revenue. Many assets are listed on a balance sheet such as a building or product. Some assets, however, are not listed on the balance sheet. Assets such as customers and employees are not listed, but they are the most valuable assets that companies have.

A company’s strength is determined by its assets, especially its liquidity. A liquid asset is cash or is easily converted to cash, making it more stable in times of emergency. However, businesses are not supposed to hoard cash; they are meant to invest in other assets and utilize them to increase the return in productivity. For example, you may purchase a machine that increases production. The key is balancing liquid assets with the assets you utilize.

Financial Ratios

Financial ratios are formulas that provide information about the company’s status. The information used to find financial ratios is typically taken from the financial statement. Ratios are used to find a variety of information, including trends, liquidity, profitability, assets, and financial leverage.
The following are some more basic ratios you will need to navigate your financials.

Ratio Formulas:

  • ROA (Return on Assets) = Net income/Total assets x 100
  • Inventory Turnover = Cost of Goods Sold/ Inventories
  • Revenue Sales Growth = This year’s revenue/ last year’s revenue -1 x 100
  • Earnings Per Share Growth = This year’s EPAs/Last year’s EPAs -1 x 100

Liabilities

Liabilities are money that you owe or a debt. Mortgages or credit balances are liabilities. Liabilities are a measure of financial health. Too many liabilities are an indication that the company is in trouble, particularly if the liabilities exceed the assets. Liabilities may be short term or long term. Short term liabilities are considered mature within a year, and they typically have lower interest rates. Long term liabilities last longer than a year. They are a greater risk, and have higher interest rates.

Equity

Both assets and liabilities are used to determine equity. Your equity, in turn, will determine what type of business risk you are. Lending institutions and investors examine your equity carefully. Good equity is associated with being a low risk investment and it makes you a low risk borrower.

Equity Equation:

  • Assets – liabilities = Equity
  • Essentially, equity is what you have left after paying off all of the debts that you owe.
  • Issuing stocks to shareholders can create equity. For stockholders, equity is what they would have after liquidation. A higher equity ratio indicates that they will earn more money.
  • Equity Ratio = Shareholder equity/Assets x 100
  • Understanding equity and what it influences is necessary to improve your business acumen.

Practical Illustration

Tim is considering a small business loan to purchase some new equipment for his company. He estimates that the equipment will improve productivity by 10%. His total liquid assets equal $100,000. His total liabilities are $85,000. He is not sure if he has the equity for the 5-year loan that he is hoping for, but he fills out the application. The loan amount that he applies for is $25,000.

 

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