Finance is the lifeblood of every business or organisation. Every employer cares about the prosperity of their organisation and any candidate who does not understand the fundamentals of finance will, in the eyes of an employer, be at a disadvantage when it comes to a promotion. Whilst it is true that most businesses have accountants to “prepare the numbers” this is no substitute for understanding core finance terminology. If you understand finance terminology and concepts, you will be ready to engage confidently with the boss when that promotion opportunity next comes around.
Here are some key financial terms and concepts that you should understand.
1. Financial Accounts and Management Accounts
Every company has to prepare financial accounts annually and file these with the Companies Registration Office. For large companies, the term encompasses a balance sheet, profit and loss account, auditors report and directors report. Smaller companies may have some exemptions although all companies must, as a minimum, file a balance sheet annually.
In contrast, management accounts are prepared monthly and distributed amongst the management team, typically 5-10 days after each month end. Management accounts provide directors (and managers) with a timely performance snapshot so that managers can understand how the business (or an area of responsibility) is performing against the annual plan (budget). If a business is undershooting revenue or incurring excessive cost, the management accounts will highlight this to that management can take corrective action to get the organisation back on track.
2. Balance Sheet and Profit and Loss
A balance sheet is a list of assets owned and liabilities owed at a point in time. Look at any balance sheet and it will be dated “as at” a date in time. An organisation will prepare its balance sheet annually to the same date. This enables any reader to identify and compare movements in assets and liabilities year on year.
A Profit and Loss account is a record of the revenue earned and costs incurred in running the business. The difference between revenue and cost, if positive, is profit. Look at any Profit and Loss account and you will see that it is dated “for the year ended.” The Profit and Loss account describes what has happened during the 12 months between two balance sheet dates (as explained above). Reviewing the Profit and Loss account in conjunction with two balance sheets enables a reader to understand not only how a business has performed but also how it has used profit and cash generated by the business during the year.
Understanding the link between a Balance Sheet and Profit and Loss account is fundamental to financial literacy and will help you to interpret the performance of any business.
3. Budget and Forecast
A budget is an annual financial plan set by an organisation. It sets out the financial ambitions for the organisation comprising a revenue target and the (maximum) costs that may be incurred to deliver that revenue. In normal times, most organisations seek year on year turnover and profit growth so every year’s targets will typically be higher than the previous year.
In contrast, and as the name suggests, a forecast is an attempt to produce a “best guess” of how the business will actually perform for the year, based on how it has performed so far. Organisations typically prepare forecasts twice or three times within a year. When the forecast revenue or profit is projected to fall below budget, managers will take remedial, sometimes drastic action, to try to meet annual budget performance expectations. A forecast is different to management accounts because it projects likely future performance (i.e. for the rest of the year) rather than actual performance delivered in past months.
4. Profit and Cash
Profit is the difference between revenue and costs. Whilst most people will be aware of this, what is less well understood is that profit is not the same as cash. The main explanation of why these two concepts differ relates to the existence of trade credit.
To explain, consider a simplified example. A business buys £100 of stock on 1 January, on 30 days credit i.e. it does not have to pay the supplier of the stock until 31 January. It sells the stock to a customer on 10 January for £300, also on 30 days credit terms. Now you will appreciate that the company has made a profit of £200 (i.e. £300- £100) on the sale of the stock. But consider the cash position. The business has not paid or received any cash in January. In its January management accounts (see earlier), the profit and loss account will show a profit of £100, on turnover of £300. But the management accounts will also show zero cash for that month.
The significance to a business of this difference cannot be overstated. The supplier in this example expects to be paid on 31 January. However, the business will not receive cash until 9 February (or later if the customer delays payment). If this business had no cash reserves, then it would suffer liquidity problems because it cannot make its supplier payment. This issue would of course be magnified in real life potentially putting the very survival of the business at risk . Every employee, whatever their role or responsibility, should appreciate the importance of profit but understand the criticality of cash.
5. Capital Expenditure and Operating Expenditure
“Capex” is a shortened term used to refer to capital expenditure. It reflects investment spending on assets. Capex items include assets bought for use over a number of years, such as buildings and motor vehicles.
“Opex” refers to operating expenditure. These are ongoing expenses and expenditures associated with running a business and may include energy costs, repairs and maintenance expenses and wages.
Knowing the difference between capex and opex, and their effect on profit, is important to understanding business decision making. Operating expenses reduce profits immediately whereas capex items do not, as the cost of such assets is reflected (charged) over many years. Business decisions can often be influenced by the effect they have on profits so understanding this distinction can help you to better understand business decision making.
Understanding finance starts with knowledge of financial terminology and concepts. Finance skills develop through application and can play an important part in helping you secure your next promotion.