COGS | Usman Sheikh

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.

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.