Business finance vs. personal finance: The important differences
You’ve likely been managing your own personal finances for years, so it might be tempting to just apply the same principles you use for your personal finances to your business. But there are important differences to consider.
Becoming a small business owner can be incredibly rewarding, but typically doesn’t come without some stresses, especially when it comes to financing and making sure you have the capital to keep things moving smoothly. You’ve likely been managing your own personal finances for years, so it might be tempting to just apply the same principles you use for your personal finances to your business. But there are important differences to consider.
First, what’s the same:
With both personal and business finances, you want to reduce expenses, invest long term, and maintain a good credit score. At least those sound principles carry over! But now let’s take a look at what you’ll need for your business that you likely won’t have in your personal life.
Getting started: A basic business plan
Every successful business starts with creating a solid business plan: it’ll help you focus your energy and clarify your goals, and serves as a roadmap for how you should structure, run, and grow your business.
From a strategic perspective, your business plan should cover: what your company does, who your target customers are, what your market looks like (how many customers you can potentially reach and who you’re competing with for their business), your marketing plan (how you’ll get new customers), and your operations plan (who you employ and how you get the job done). Often, a mission statement or vision for what you want the company to become is used as a guiding principle for your business strategy – kind of like a vision board for your personal life.
From a finances perspective, your business plan should cover: revenue, expense, and profit. Your profit is the money left over after you deduct your expenses from your revenue. In order to make more money, you will want to improve your small business’s gross margins. The gross margin is the number of total sales revenue after accounting for all of the costs necessary to produce your goods or services (this is called the cost of goods sold, or COGS). The gross margin is calculated by subtracting COGS from revenue, and then dividing this number by the revenue.
Additionally, there are profit margin calculators online if you don’t want to do the math yourself. By keeping track of revenue, costs (including COGS), profit, and gross profit margin, you will be able to understand the true health of your business finances and make informed decisions about leverage, investments, and growth strategies.
Finally, you’ll want to write your introduction last. Your business plan should start with a short, sweet “executive summary” that helps an investor, partner, or other interested party quickly understand all the most critical elements of your plan.
Understanding the most important difference: Leverage
After your business plan, thinking about how to fund your company is probably the most important thing you need to focus on. An important difference between personal and business finance is the use of leverage as an investment strategy, which basically means you borrow money to invest in your future. Leverage is a common practice that, when done right, supports small businesses and helps them expand through the access to capital.
In order to fully understand leverage, you must understand two important terms: debt and equity. The debt to equity ratio, which is a company’s total debt divided by its total equity, is a good signal to investors as to the health of your business. This ratio is a tool that measures the debt a company has (for example, short and long term loans) to the equity (retained earnings and assets owned by the small business). The smaller the ratio is, the safer the small business is seen by loan officers, and the more capital they are likely to give you access to.
Using leverage in personal finance can mean devastating losses, as in your car or even your house. But in business, it allows you to increase your ability to invest in your company without having to personally put forward all of the capital.
If you leverage your business, this isn’t necessarily a bad thing. In fact, it can be highly beneficial! It is just important to not obtain more loans than you are able to pay back.
Keeping business and personal finances separate
It’s important to separate your business and personal finances as completely as possible, which for most small businesses includes a business checking account and credit card, and oftentimes, a small business loan. Avoid paying personal debts or bills from your business accounts and vice versa. Make sure your business finances are official by registering your business and obtaining a federal tax identification number.
This approach will make book-keeping easier, filing your taxes less complicated, and will make you a more credible candidate for loans and other financing.
Accounting and business taxes
It’s also important to have a plan for your accounting and business taxes. Track your expenses, set up payroll systems, and determine your tax obligations. In order to monitor your business growth and create financial statements, you will need to accurately track your business’s expenses. Additionally, keeping track of expenses will allow you to organize your filings and prepare your returns come tax time.
If you are paying yourself, decide whether you’ll manage accounting yourself or use an accountant. With accounting, you should also decide which method you want to use: cash or accrual. With the cash method, you recognize revenues and expenses when they are received and paid. With the accrual method, revenues and expenses are realized when the transaction actually occurs; this method will require you to track receivables and payables as well. If you are managing your accounting yourself, there are a number of tools available, such as Shoeboxed, Quickbooks®, or Xero which help keep track of your business finances.
Running your own business can be one of the most fulfilling career decisions you’ll ever make. And with a clear plan in place, a confident understanding of how to use leverage to finance your operations, and a disciplined approach to business accounting and taxes, it can be not just personally but financially rewarding as well.
For more helpful small business resources from us, visit FightingForSmall.
Our editorial content is intended for informational purposes only and is not written by a licensed insurance agent. Terms and conditions for rate and coverage may vary by class of business and state.
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