Sometimes it takes money to make money, as the saying goes.
But when you don’t have the money and need to borrow, and you don’t have the bandwidth to study up on finance and accounting terms and conditions, the fat stack of documents you’re about to sign can prove daunting.
In this series, we will examine several topics that affect small businesses seeking financing using the example of two fictional local competitors: Buddy’s Bakery and Callie’s Cupcakes. While the respective (imaginary) businesses are doing well, the owners have a lot to learn when it comes to their finances.
In order to get Buddy and Callie started, we’ve defined a few financial terms that often come up in business; terms any business owner should familiarize themselves with in order to feel comfortable and confident when it comes to finances. While it’s impossible to know everything, you don’t have to have an accounting degree to understand the basics.
Want to learn more? Look no further.
What is Accounting Rate of Return (ARR)?
For starters, accounting rate of return, also known as “simple rate of return,” is used by a small business to decide the assets or projects it would like to invest. Calculating the ARR is useful if you are looking to determine the expected profit, or return, on the investments you make in your business. It is also often used to compare and contrast multiple projects.
In its simplest form, the ARR of a project is the following calculation: divide the annual accounting profit by the initial investment in the project. For a real-time application, let’s consider this scenario:
- Buddy’s Bakery invests $250,000 in equipment.
- The total profit it has made over the past five years is $50,000.
- If we divide $50,000 by 5, we come up with an average annual profit of $10,000.
- From there, we divide the investment of $250,000 by 5, making the annual average investment $50,000 per year.
- To come up with the ARR, we simply divide the average annual profit of ($10,000) by the annual average investment ($50,000). This makes the ARR for the bakery investment 20%.
What is Annual Percentage Rate (APR)?
On the other hand, annual percentage rate, or APR, is a more common term. Anyone with a mortgage or credit card is probably somewhat familiar with the term and how it works. A loan’s APR provides a borrower with the bigger picture of their payout because it showcases the total price and accounts for the interest rate on an annual basis. In addition to interest, APR includes fees such as closing, origination and documentation fees.
Speaking of interest, it is something to look at on a deeper level when examining APR. For example, interest is affected by the life of the loan and its repayment schedule. And in some instances, loans are offered with provisions that decrease the interest rate as the balance is paid off.
What is Internal Rate of Return (IRR)?
IRR is a percentage that determines the investment return on capital expenditures or investments and ignores external factors. Also, IRR is an interest rate that equalizes cash spent on an investment with cash that comes in because of the investment. IRR can also occur when net cash related to an investment equals zero.
Its real-world application determines if the cost of a project, investment or expense was worth it; or, it is calculated to see if a business made money on a project or not. In the case of our competing bakeries, if Buddy’s cost of capital is 6%, any opportunity with an IRR of 6% or higher is a viable option he can consider. So, when his accountant presents him with an investment opportunity with a yield of 4%, Buddy knows this is not worth consideration because it falls below his 6% cost of capital. However, a few weeks later, when his accountant shows him an option with a 7% yield, Buddy knows this is worth a second look and possibly pursuing because it is above the cost of capital.
What is Annual Percentage Yield (APY)?
First things first. Written up as a formula, APY = (1 + r/n )n – 1
r = quoted annual interest rate; and n = the number of times interest compounds per year.
APY is the rate of return on an investment that accounts for compounding interest. This is assuming funds will remain in an investment vehicle such as stocks, bonds or CDs for 365 days. In one case, it can evaluate the true return on an investment. For example, if Callie invests $1,000 in a CD with a 12% interest rate, over the following 12 months, we can assume that with the bank compounding 12% interest every month for a year, it will grow to an APY of $1,126.83, or 12.683%.
On the flip side, APY also determines the true interest rate paid on a loan; and/or help a business owner to standardize a varying interest rate into an annualized percentage. In Callie’s case, she is considering bank loan and would like to know what the loan’s APY will be. If she uses the above formula for a 12 month $1,000 loan at 2.12% interest, at the end, she would end up paying $1,021.41, an APY of 2.14%.
What is Factor Rate?
If a business finds itself in need of short-term financing, one important component is its factor rate. One can determine this by dividing financing cost by a loan amount. Factor rates are typically in a decimal amount and vary from 1.1 to 1.5. Factor rates also rely on variables such as the average monthly sales, industry, and length of time in business.
In the instance of Callie’s Cupcakes, if she takes out short-term financing for $100,000 at a factor rate of 1.18 over a 12 month term, Callie will be repaying a total of $118,000.
With a basic grasp on these terms, Buddy and Callie can face their finances from a more realistic standpoint. It can empower them to find out what funds are going where. That will hopefully be an easier and smoother ride. But what do they know about the impact of cash flow on their respective businesses? Stay tuned to learn more.