In business, there are three main “languages” – accounting, finance, and economics. While there are many other disciplines in business, such as marketing, human resources, operations, etc., it’s the core principles and terminology behind accounting, finance, and economics that drive decisions across businesses. In this guide, we will break down the language of business in simple terms.
What is Business, Really?
At its core, business is decision-making under uncertainty. Managers have limited information and can’t predict the future, yet they have to constantly make decisions about what a company should do tomorrow, next year, and next decade.
In order to support decision-making under uncertainty, the languages of accounting (historical information), finance (forward-looking information), and economics (external forces) all help managers make better decisions.
It’s important to start with a solid understanding of the accounting system, how it works, and how the financial statements all fit together.
Within any business, the accounting language is critical to understand, yet far too few people properly understand it.
Companies produce three main financial statements:
Businesses need a way to keep track of their overall financial position, including tracking revenues, expenses, capital, and other items. The rules-based system of accounting enables companies to track these items and communicate the results to a wide range of interested parties.
Once you have a solid understanding of the accounting language, it’s equally important to understand the language of finance. Accounting is backward-looking, while finance is forward-looking and therefore critical to decision-making processes at companies.
The accounting numbers that have been prepared by the accountants need to be analyzed and interpreted to create forward-looking projections about what might happen in the future.
The rules-based system of accounting is great for ensuring accurate, consistent, and reliable information but it does not necessarily indicate where value is being created or destroyed.
The main language of finance is centered around assessing value, rates of return, and looking into the future to determine how to maximize the value of the firm.
When you think of the language of finance, think of:
Looking into the future
Rates of return
Finance is an important language of business to overlay on top of accounting for managers to make decisions under uncertainty.
Economics is the third distinct language of business. It looks externally outside the organization and at the “laws” of behavior in markets, governments (regulation), and individuals.
It’s one thing to make a financial forecast using financial methods, but it’s another entirely to make sure that forecast is supported by a sound understanding of supply and demand, consumer preferences, price sensitivity, etc.
Understanding the language of economics is critical, as businesses do not exist in a vacuum. They are subject to external forces and knowing how those forces work is absolutely critical.
In the realm of economics, managers are speaking about:
Supply and demand (and equilibrium)
There are of course many more economic principles to understand, but these are some of the key concepts to understand in business.
An Example of the Different Business Languages
Imagine a company faced with the decision of: should we produce a new product or not?
This example requires insight from all three business languages.
Based on historical accounting information, it would be possible to make an estimate of how much it would cost to produce that product. The past financial statements and accounting reports could tell you the average cost of production, including labor, rent, overhead, etc. This figure would be a “fully baked” number because accountants always allocate costs, like overhead, across divisions. What this means is that the cost estimated from accounting systems may not reflect the true economic cost.
Using some financial estimates, it would be possible to make an estimate of how much it would cost with a forward-looking lens. A financial analyst would look at the “true” cost of cash flow required to produce the new product, including any changes to overhead, staffing levels, and production capacity. This number would include all expenses and capital expenditures to determine the true (estimated) economic cost of producing the product.
In order to properly price the new product and forecast demand for it, a solid understanding of supply and demand, as well as other substitute goods and price elasticity all need to be taken into account.
The economic lens may say, here is a reasonable range of prices to charge, and here is a reasonable estimate of the volume that can be sold at that price.
Combining All Three Business Languages
At this point, a manager can take the accountant’s view of smoothed costs, the finance view of cash flow, and the economics view of price and volume to make an informed decision.
As mentioned above, business is decision-making under uncertainty. Even with a complete understanding of all three languages of business, it may be hard to make the “right” decision.
Execution and Other Languages
You may be asking, aren’t marketing, operations, human resources, technology, and other areas of business important languages we well? Yes, they are! The difference though is that they are all part of execution, rather than the core decision-making process.
For example, having a good idea for a marketing campaign shouldn’t drive the decision to produce a new product. Instead, marketing should play a critical role in executing the plan once the decision has been made based on sound accounting, finance, and economic principles.
This has been a guide to the three main languages of business. We have only scratched the surface in this article. To keep learning and advancing your career, we highly recommend our online business courses!