Difficulty Understanding Finance in Business

Here are a couple of examples of people not understanding finance in business. Some people just don't get the basics, no matter what you say to them. It's like talking to a wall. You don't have to be one of them if you just understand the basics of business finance.

I gain nothing by pointing out the failings of others, but it's my hope that you gain something. You can either go through sad experience or learn from the sad experience of others.

Here's a chance to learn.

It's important to be good at understanding finance in business because it builds confidence in what you're doing, and help you understand how to grow profits instead of simply growing the business.

The Costly Parade

In this first example of understanding finance in business, let me set the stage a bit. A not-for-profit organization built a float and participated in a parade as a way of building name recognition in the community. The float cost money as you would expect. The organizer of the parade entry got a few people to sponsor the event through some clever gimmicks and raised money during the parade to offset the cost of building the float.

At the end of the parade, the money was totaled and it looked something like this:

  • cost of float: $600
  • money raised: $500
Okay, so it doesn't take a genius to figure out that the net cost of the parade to the organization was $100. Nevertheless, the club treasurer didn't see it that way. Instead, he saw the cost and revenue (from the same event) as being quite separate pots of money. Therefore, he reported to the club that the cost of the parade was $600. Of course, this raised eyebrows among the board members.

When the point was brought up that there was money raised to offset the cost of the float, the treasurer's response was simply, "But, that could have been used for other things," as if the $500 income came from a source completely unrelated to the event. It's true that the money could have been used for other things, but it rightly needs to be used to offset the cost of the parade as it was the parade that generated the revenue in the first place.

If you don't associate the revenue with the investment, there is no way of determining the return on investment. From the treasurer's point of view, the promotion of the organization cost the club $600 and there was a windfall of $500 that came from somewhere else that he wanted to spend on "other things."

In fact, the way the treasurer was understanding finance in business was much worse than that. He viewed the $600 as a cost, which it was. He also viewed the $500 as essentially another loss to the club because that income "...could have been used for other things," but was instead lost to cover the costs of the parade.

Any reasonable person can see that the net cost to the club was $100, as the cost of participating in the parade must be associated with the revenue gained by the same event. When explained to the board, the $100 net cost of promoting the club seemed very reasonable indeed.

It's no wonder the club has financial problems - they don't run their operation with any kind of business sense to speak of. As a not-for-profit, the organization relies on donations of other people's money. Whenever you're dealing with other people's money, you need to be especially careful about what you're doing. That means you need a reasonable understanding of finance in business.

Revenue is "Spending Money" - think again

Here's a story about a man who ran an auto body shop, right into the ground, because he wasn't generating any profit at all. The more jobs he brought in, the deeper in debt he got himself. When asked about how he was going to pull himself out of the hole, he pointed to a $5,000 job here and a $6,500 job there that he had just taken in.

In his mind, that was $11,500 that he could apply to his debt. He was wrong. His lack of understanding finance in business had led him to indebtedness, and he was only digging himself deeper. He was thinking that the gross revenue of $11,500 was all his to spend. He was ignoring the fact that to work on those cars, he'd have to fork out lots of money in direct costs associated with repair and restoration of the vehicles. Things like:

  • labor
  • parts
  • paint
  • materials
  • supplies
  • utilities
In addition, there were indirect costs that his lack of understanding finance in business kept him from seeing. Things we call overhead like:
  • rent
  • utilities
  • insurance
  • taxes
In the real world, you're doing well if 10% of your gross sales wind up as profit in your pocket. Using that as a measuring stick, those cars that would bring in gross revenue of $11,500 would only put $1,150 in his pocket, provided that the following was true:
  • no mistakes were made
  • no materials were wasted
  • employees worked at peak efficiency
  • there were no "come backs" because of flaws in workmanship
  • no delays were encountered in getting the work done

You see, it's about 10% profit in a perfect world, and when you're dealing with something like an auto body shop with employees working on the cars (instead of individuals with a vested interest in the business), you're going to have two sets of interests. One interest is making profit to payback the investment in the business. The other interest is simply in a paycheck.

Summary - Understanding Finance in Business

These examples show individuals who don't have a clue when it comes to business finance. It's simply a matter of revenue from an activity minus the cost of performing that activity that equals the true income or profit. If either of these individuals had taken time to put together a simple financial model as part of their business planning, it would have gone a long ways towards helping with their understanding finance in business matters that they were engaged in.

You don't have to be an accountant to understand how to balance raw incoming revenue with outgoing expenses. It's real simple to do. Learn from their errors and ignorance, and you'll have a better handle on true costs of doing business and what profits are reasonable to expect. This kind of learning can be applied to any of the small business ideas that you might consider.

Done with Difficulty Understanding Finance in Business, take me back to Small Business Finance

The only business you'll really ever be part of is your own.

Wondering about what to do with your savings so inflation doesn't eat it up? Start your own enterprise. It's a good way to invest your capital and make it work for you. Who will be better at keeping an eye on your investment than you?