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5 Key Financial Business Metrics

“If you don’t measure something, you can’t change it. The process of leadership is one of painting a vision, then saying how you’re going to get there, and then measuring whether you’re actually getting there. Otherwise, you risk only talking about great things but not accomplishing them.” Mitt Romney

As business owners we have to have our ears to the ground constantly to gauge how the business is performing. With the number of things happening in parallel, keeping up to speed is often a juggling act.  The financial management of business is a critical aspect of the overall functioning of the enterprise. Mismanagement in this area can have detrimental ramifications, these can essentially put you out of business. Keeping track of financial activity on a periodic basis is a necessity. To make the process of review easier, specially when one is running multiple businesses or business units, is to use metrics to get an overall perspective. Outlined below are five key financial metrics I use to assess the health of a business.

1. Net Cash Flow: This is by far one of the most important metrics, and one has to continuously keep an eye on it. Net cash flow is simply calculated by subtracting cash inflows with outflows. Alternatively, it can also be calculated by adding depreciation and other non cash expenses to net profit. Without adequate liquidity a business is often unable to reach its potential and will suffer severe growth issues. Use this metric to monitor the liquidity health of your business and analyze trends in areas beginning to run low on reserves. To learn more about how to calculate and use the net cash flow metric please click here.

2. Turnover Growth: Evaluating and estimating revenue growth is a tricky and challenging process. It is often based on assumptions and does not take into account unexpected events and scenarios. It requires us to take into account industry growth averages and our share of the market and industry pricing strategies, and then come up with a reliable metric. However from an historical perspective this metric can provide a reliable indicator to judge the performance of the business and the sort of average growth figures to expect. To learn more about how to calculate and use the turnover growth metric please click here.

3. Gross Margin: Gross margins is a very good metric for investors to evaluate the viability of a business. Gross margins are usually bench-marked against industry averages to see how efficiently a business is structured. As business owners, we have to do all we can to steadily increase this metric or find alternative methods to increase the metric through diversification. Periodic review cycles need to be implemented to ensure that the business is growing in the right direction and at the right pace. To learn more about how to calculate and use the gross margin metric please click here.

4. SG&A Growth: Sales, General & Administrative (SG&A) expenses include, all salaries, indirect production, marketing, and general corporate expenses. This constitutes the bulk of expenses that a business incurs and should be constantly reviewed. Each item needs to be evaluated and aligned with it’s contribution to the overall business vision. There needs to be a constant monitoring of marketing and IT expenditure to ensure that we are generating sufficient ROI’s for our campaigns and implementations. To learn more about how to calculate and use the SG&A growth metric please click here.

5. Operating Margins: This metric allows you to get an idea of the profitability of the business, and the potential to grow and scale the business further. To calculate this metric we need to know the firm’s operating income, which is revenue minus cost of goods sold (COGS) and general and administration (SG&A) expenses. This figure needs to be further divided by the firm’s revenue, to arrive at the percentage value of the firm’s operating margin. Businesses which operate with low operating margins must strive to reach revenue levels where they can take advantage of economies of scale. However businesses with higher operating margins can focus on providing a core group of products or services really well to its target segment. To learn more about how to calculate and use the operating margins metric please click here.

Financial metrics are important to keep us abreast about the financial health of our business. However, one should not become fanatical in using them as the sole indicator of how a business needs to be run. In many examples I have seen business owners become obsessed with hitting certain financial targets whether it be operating margins or net cash flow at the expense of the future growth of the business. There needs to be a balance and one needs to be able to see the bigger picture as well. The metrics discussed above provide an holistic picture of the current health of your business and should be used to identify areas of pain to help the business grow faster.

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Financial Metric #5: Operating Margins

“Be precise. A lack of precision is dangerous when the margin of error is small.” Donald Rumsfeld

One sets up a business with the aim of providing prospective customers with superior products/services and in return, to be highly profitable. Operating margins tell us how much money the business makes on every $ of revenue. To calculate this metric we need to know the firm’s operating income, which is revenue minus cost of goods sold (COGS) and general and administration (SG&A) expenses. This figure needs to be further divided by the firm’s revenue, to arrive at the percentage value of the firm’s operating margin. For example if the operating income is $5 and revenue is $100 the operating margin of this business is 5%. If all the other firms in the same industry enjoy operating margins of 10%, then this particular business has major issues regarding their COGS and SG&A. There are a couple of things you should keep an eye on when evaluating this metric.

1. Revenue: Calculate where the majority of revenues is being generated from? Is there a particular product or service which contributes significantly to the overall figure? Is the revenue spread out evenly over many product or services? Each scenario poses potential opportunities and risks. Over reliance on any one product may be risky as a long term strategy. On the other hand, spreading the business over many products or services opens up the possibility of newer competition attacking the business on multiple fronts. A balance needs to be found where revenue can be maximized.

2. Fixed & Variable Costs: Pay attention to the cost structure of the business being evaluated. If the business has a high fixed cost structure with low variable costs, then insufficient revenue generation means operating on smaller operating margins. This can be both an opportunity and a threat to the business. If the industry in question is relatively untapped, there is larger potential in promoting it’s product/service with low variable costs. However if the industry is saturated with large entrenched players, it then becomes challenging to grow the business significantly. Alternatively with low variable cost structures, the business has more flexibility and can usually outmaneuver larger companies.

3. Industry Analysis: How does the company’s operating margin compare to its peers in the industry? Finding this data is usually quite challenging, however rough guidelines can be found with hard work. Once we have these guidelines, the business is bench marked on various factors compared to the competition. This gives us the ability to compare cost structures, revenue splits as well as overall operating margin comparisons.

This metric allows you to get an idea of how profitable the business actually is, and the potential to grow and scale the business further. Businesses which operate with low operating margins must strive to reach revenue levels where they can take advantage of economies of scale. However businesses with higher operating margins can focus on providing a core group of products or services really well to its target segment. As a business owner, keep a sharp eye on operating margins and continue to evaluate how you stack up against the competition.

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Financial Metric #4: SG and A Growth

“There is one rule for industrialists and that is: Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible” Henry Ford

Sales, General & Administrative (SG&A) expenses include, all salaries, indirect production, marketing, and general corporate expenses. This constitutes the bulk of expenses that a business incurs and should be constantly reviewed. The entire concept of running a lean enterprise extends from the fact that we use an optimal mix of resources to achieve our target goals. However, this is usually not the case in the real world and businesses tend to inflate costs drastically whenever they have some success. This creates an unhealthy dependence on extra resources and also leads to complacency within the team. When cuts need to be made during recessionary periods,  there is a detrimental impact on the team’s overall performance in such organizations. From the onset we have to continuously monitor our SG&A growth in relation to revenue growth as well as industry averages. This helps keep an eye on the ball and puts emphasis on efficiency. When evaluating this metric there are a couple of factors to keep in mind.

1. SG&A Break Up & Alignment: How are costs distributed through the business? We need to identify which costs contribute significantly to overall costs. This helps us map out IT, marketing, sales, payroll and other components which usually make up the bulk of expenses. Once we have this breakdown, we can analyze each component further and see how it contributes to the overall strategic vision of the company. If your company has a short term goal of increasing market share in its industry through mergers and acquisitions, there needs to be focus on getting the right people on the team instead of bulking up marketing expenses. We see hence how breaking up the SG&A and aligning it in accordance to the business vision is important.

2. ROI: Each major component such as IT or marketing, needs to be measured. When assessing your business it is important to delve into each component to gauge which technologies and campaigns are delivering an acceptable ROI and which are not. This exercise highlights non performing costs which are being incurred without adequate return. It is through this exercise that one can eliminate these costs and make the entire business more efficient.

3. Growth %: One also needs to pay attention to how fast the SG&A figures grow when the business begins to scale. This percentage needs to be kept in check and must be reviewed regularly to ensure that costs are not being overly inflated with growth. This usually happens when we begin to hire too many people, launch unnecessary marketing campaigns or have technology infrastructures implemented when not needed. This leads to erosion of operating margins and can have a detrimental impact on growth. If possible benchmark your SG&A against industry averages as well to ensure that growth is specifically aligned with the overall strategic direction the business wants to take.

SG&A needs to be kept in control and be constantly reviewed. However, I do not like pegging its growth to some budgeted figure. SG&A growth needs to be aligned with the business vision. Restricting it from growing over a certain percentage may have a short term benefit to the business, it may however prevent it from reaching its long term goals.

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Financial Metric #3: Gross Margin

“An important and often overlooked aspect of operational excellence is regularly comparing actual costs to budget assumptions – not just the numbers in the plan. Understanding assumption deviations will help improve the accuracy of future forecasting.”Bob Prcsen

Before we calculate gross margin, we first need to know the cost of goods sold (COGS). These are direct expenses incurred in the manufacturing of a product, or the rendering of a service. There are many methods used to calculate this metric. Firstly it has a lot to do with the type of business one is running. For example, if you are running a DVD store do you include the store rent in the COGS, or as an indirect expense. Such questions will definitely come up when you are doing COGS calculations. You need to ask yourself “how is this expense related to the product/service?”and “if you were to take away this expense would you still be able to deliver the product or service?” Ultimately this will depend upon the product or service you are providing, the goal being to reach a figure which is an accurate representation of how much it costs to produce or deliver a product/service.

After calculating our COGS we can calculate gross margin by dividing gross profit (Revenue – COGS) with Revenue. If we sell a widget for $1 and we incur a direct cost of $0.4 to produce it, our gross margins are 60%. This is a very important financial indicator as it indicates how much cash will be  flowing into the business. When gross margin falls dramatically due to increase in raw material prices for example, it impacts detrimentally on every part of the business. It is therefore critical that management keep a keen eye on this metric and not let it drop below levels that will make it difficult for the organization to grow. A couple of things to keep in mind when looking at gross margins are:

1. Pricing Policies: When evaluating your business and finding ways to improve gross margins, pricing policies play an important role. When a business is in a competitive field, for example retailing of basic computer components, margins tend to erode due to competitive downward pressure. As a business owner one needs to continuously check on pricing strategies employed by competitors and how one can outmaneuver competition based on complementary services rather than price wars. Evaluating pricing strategies is hence critical to maintaining and improving gross margins.

2. Inventory Management: If your business currently holds large stock of products that are manufactured or purchased one needs to manage this rolled over inventory carefully. Left over inventory is a component of calculating COGS and when a business begins to hold on to larger quantities of inventory, margins begin to erode because of stock depreciation. Inventory must be managed intelligently to ensure that the business does not expose itself to unnecessary risks which will impact both its margins and cash flows.

3. Periodic Review: In today’s world where massive price fluctuations are a norm, one needs to pay very close attention to gross margins. This is especially true for business owners who operate with slim margins. In the past when I have been involved with product based retailing ventures, I set up weekly meetings to access this metric to understand how we were faring through various distribution channels so as to continuously adapt our strategy and plan according to prevailing market conditions.

Gross margins is a very good metric for investors to evaluate the viability of a business. Gross margins are usually bench-marked against industry averages to see how efficiently a business is structured. As business owners, we have to do all we can to steadily increase this metric or find alternative methods to increase the metric through diversification. Periodic review cycles need to be implemented to ensure that the business is growing in the right direction and at the right pace.

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Financial Metric #2: Revenue Growth

“Always be closing…That doesn’t mean you’re always closing the deal, but it does mean that you need to be always closing on the next step in the process.” Shane Gibson

Revenue growth is a metric which is spoken about widely whether you are a brand new start-up or an established business. It is the one metric which investors are always keen to learn about. Revenue is quite simply the number of products or services sold, multiplied by the price. Calculating revenue is fairly  straightforward. Evaluating growth of revenue over a stipulated period of time provides a lot of information regarding the future prospects of the company.

Early stage start-ups that do not have any present revenue, or then very little, need to develop projections to gauge future revenue. Hockey stick graphs are a norm when this information is produced, I  strongly advise backing up projections with sound assumptions and research. For established companies,  regular evaluations of revenue growth projections are required to ensure that they are being met. Some key factors to keep in mind regarding revenue growth are:

1. Industry Growth: One needs to first evaluate the growth speed of the market they operate in . This helps create broad benchmarks for future prospects. For example the overall print media industry is witnessing a massive slowdown in the west. Getting into this particular industry at this point in time is not a viable future growth prospect. However, the online media industry is booming and is growing at a phenomenal pace these days. When evaluating a business it is good to get a broader perspective on what is happening in the bigger picture.

2. Market Share: Depending on the market share the business currently holds, will directly impact its ability to grow revenue. For instance, if you are a market leader in office automation products like Microsoft and control over 70% of the market, a 10% yearly growth is not a realistic target. However if the market is fragmented like the hand held mobile sector, a new entrant like Apple was able to come in, almost immediately take a substantial share in the market, and has aggressive growth targets for the next couple of years. Therefore, evaluate your market position when creating revenue growth estimates.

3. Pricing: Depending on the type of pricing strategy adopted, one can determine what sort of revenue growth is possible. If for instance,  the business is planning on increasing prices next year, and even though this could positively impact margins, it could have a negative impact on units sold. This will impact directly on revenue and thus growth estimates will have to be adjusted likewise. The business must find a balance between its pricing and revenue growth strategy to reach its target.

Evaluating and estimating revenue growth is a tricky and challenging process. It requires a lot of assumptions to be made and does not take into account unexpected events and scenarios. However from a historical perspective this metric can provide a reliable indicator to judge how the business has performed and what sort of average growth figures to expect.

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Financial Metric #1: Net Cash Flow

“Performance stands out like a ton of diamonds. Non performance can always be explained away.” Harold S. Geneen

Last week I dedicated an entire series to better management of business cash flows. This is a critical function and holds the key to success for many companies. When I evaluate the health of a company, this is probably the first financial indicator that I look up. I have learnt through experiences that one can have a fantastic business model, be earning a nice profit providing a product/service, but if the business is plagued with recurrent liquidity problems I am wary about making an investment into the venture. Net cash flows is simply calculated by subtracting your cash inflows from your outflows. When looking at this metric there are a couple of things to look for:

1. Cash Inflow Trends: This provides data regarding how cash inflows have progressed over the historic period under evaluation. Is there a stable growth of inflows over time? Are the inflows cyclical in nature? How long does it take for an order to be converted into a cash inflow? What one is looking for is substantial evidence regarding the viability of growth and stability of cash streams of the business .

2. Cash Outflow Trends: At what percentage do cash outflows grow with an increase in cash inflows? Does the business experience diminishing returns after a certain inflow threshold has been reached? Are outflows cyclical in nature or is there a fixed outlay? If a business has a high fixed cash outflow without the support of growing inflows, there is bound to be a substantial cash glut at some point. Also, if inflows are slow to be realized into cash and there are long periods where net cash flow is negative, this does not reflect well on the business sustainability.

3. Overall Historic Trends: Equating both the inflow and outflow streams we get a good overall picture of the net cash flow situation over a certain period of time. This will show how resilient the business is in recessionary periods and how it conserves and invests cash during boom periods. If managed well we should see a positive net cash flow situation that will be a good representation of the overall health of the business. 

A business which is constantly plagued with cash flow gaps will have a challenging time expanding the business. Such a business must re-evaluate it’s current business model and re-analyze it’s inflow and outflow trends. Through this analysis one should be able to arrive at pain points in the current model such as “excessively long payment cycles,” and find ways to resolve this issue by tweaking operational procedures and overall business strategy. 

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