Financial concepts you need to know if you want to become an entrepreneur
We find ourselves in the golden age of entrepreneurship. According to statistics from the Global Entrepreneurship Monitor (GEM), there are 582 million entrepreneurs worldwide. In addition, GEM also reports that 40% of new entrepreneurs in 35 out of 50 countries agree or strongly agree that their motivation for launching a business is to make a difference in the world.
Motivated entrepreneurs and their startups are an indispensable component of economic development. Without them there would be less innovation, less productivity, and fewer job opportunities. However, starting a new business comes with a number of challenges and risks, not least of which are financial.
Some entrepreneurs start their businesses without adequate financial education and overlook the importance of good planning, finding sources of financing, sound credit management, and more. Anyone wanting to embark on their own adventure into entrepreneurship needs to know some basic financial concepts, products, and services to be able to take advantage of their benefits and thus grow their businesses.
For this reason, and as part of our effort to improve the financial health of both society and entrepreneurs, we bring you this article highlighting some financial concepts that you should know if you want to start a business.
At MAPFRE, we are committed to financial education because we know that it empowers us and gives us the confidence we need to make decisions, recognize risks and opportunities, and take actions to improve our well-being.
10 financial concepts for entrepreneurship
Simply put, an asset is a valuable resource that someone owns (in this case, a company) with the hope that it will generate a future profit (whether economic or not). In accounting, assets are all the goods and rights of a company acquired in the past and expected to bring future profits. All assets have the potential to bring money into the company, either through use, sale, or exchange.
A liability is the opposite of an asset. From an accounting point of view, liabilities represent the debts and obligations with which a company finances its activity and serves to pay for its assets. They are possessions that oblige you to spend money on a recurring or one-off basis and that do not generate income.
An example of this is a loan from a financial institution. By acquiring such a loan, you are obliged to pay the principal and interest to the provider. Liabilities also include almost any kind of property — a car, a house, or your children’s toys — because they are not likely to generate profits for you, but rather oblige you to incur costs.
Many of you probably know it as profit margin. It is usually calculated as a percentage of sales. In short, the gross margin is the direct profit a company makes on a good or service, i.e., the difference between the selling price of a product and its production cost. This margin is always calculated without deducting personnel costs, overheads, and taxes. It is used to determine whether a business is profitable, because if the gross margin is negative, the remaining costs will be impossible to cover.
A relatively simple concept, opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen, including the profits you could have obtained if you had chosen a different alternative. Put another way, they are the resources that you forgo or that represent a cost because you did not choose the best possible alternative, when you have limited resources (usually money and time).
There are many examples of this in small businesses. For example, if you spend 10,000 euros on new computers and office equipment, not only have you spent this money on these items, but you have also foregone spending this money on renovating the office space.
Risk and risk management
Risk is one of the key concepts in the world of finance because, to a large extent, it is what determines profit. For example, if you own a property and rent it out, it becomes an asset. However, when you buy that property, you assume a risk, such as the property losing value due to a deterioration in the conditions of the area where it is located.
Risk is a constant in the business world and in the finance world in general. Because these risks exist, they must be managed well. If you are interested in this topic, we invite you to learn more about it, because there are many risk management and control strategies that we could not include in this article.
As the name suggests, the liquidity ratio measures the liquidity of a company, i.e., its ability to meet its short-term financial obligations. This term reflects the financial capacity of a company at a given point in time. The data used to calculate liquidity ratios come from the balance sheet, specifically from current assets and current liabilities. There are different formulas used to calculate it and, although all of them individually measure the liquidity of a company, it is worthwhile to use them together when performing an analysis, as some may be biased due to how the company is structured. For example, the size of the company’s inventory may be a determining factor.
Return on investment
Also known as ROI, return on investment is an indicator that allows us to evaluate the profitability of an investment based on the capital allocated and the profit obtained.
In the world of entrepreneurship, it is also the time it takes for an entrepreneur to recover his or her initial investment. It is important to calculate the return when considering purchasing an asset for the company. This will allow you to see whether the investment will pay off in the future.
The higher the contribution margin, the higher the company’s profit. This term is the difference between what it costs to produce a product or service and the price at which it is sold.
While the contribution margin and the gross margin appear quite similar, they are two complementary profitability indicators that are different in scope. The contribution margin only considers variable costs, albeit all of them (not only production costs). On the other hand, the gross margin refers only to industrial processes, including what is known as full cost, or the direct, variable, and fixed costs of manufacturing a product. Understanding the differences between these concepts will be of great help when making financial decisions.
Leverage is a strategy used to increase the returns on an investment. This type of strategy involves using credits, fixed costs, or other investment tools to multiply the final return on an investment, either positively or negatively. Having a higher degree of leverage implies higher risks. So, while it can greatly increase gains, this strategy can also significantly increase losses.
Known popularly as the break-even point, this is the point at which your start-up reaches an equilibrium where costs equal total revenues, i.e., zero profit, but also zero loss. At this point, the next step is to generate profits to make your company profitable.
Calculating the break-even point is one of the easiest ways to find out if your start-up is viable, as you will know the expenses you will have and the sales you will need to cover them. It will be essential to have a medium- and long-term economic plan that will help you to reach this break-even point, as well as a projection to maintain and exceed it and thus generate profits.
In short, these are just some of the many concepts that exist within the great world of finance, and ideally each entrepreneur should be advised by professionals and receive further financial education. The more you internalize these financial concepts, the more you will be able to analyze and make informed decisions in order to become an entrepreneur. Keep in mind that we have selected only a few for this article, but they all play an important role in entrepreneurship. Our advice is to find the time to understand finance, as a sound financial education will be key to a thriving business.
Moving away from finance and focusing on entrepreneurship, in June 2021, we contributed to the report on the impact of COVID-19 on entrepreneurship in Spain, through the MAPFRE Observatory for Sustainable Finance and in collaboration with the Spanish Entrepreneurship Observatory. The report offers relevant data on the impact of the crisis on entrepreneurship from a triple perspective: from the Spanish population in general, from the population that has a business, and from the perspective of a panel of experts. It also highlights five levers for the future to boost entrepreneurial spirit:
- Improve human capital, the main determinant of the quality and success of future entrepreneurial initiatives.
- Improve training in entrepreneurship through active methods at all levels and in all specialties of the education system.
- Improve and increase collaboration and knowledge transfer between universities and research institutions and companies.
- Improve the regulatory framework, soundness, coordination, and efficiency of institutions, boosting their ability provide rapid responses to the changing problems of the economic and business reality.
- Improve the growth and scalability of initiatives.
Over the past three years, more than 30 start-ups have succeeded in entering new markets via the Insur Space program by MAPFRE Open Innovation. We offer all entrepreneurs the full range of MAPFRE’s resources to grow together in the countries where we operate.