Posts tagged "customer acquisition"

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.

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.

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. 

Related Posts:

5 Tips for Better Cash Flows

Metrics for Business

“For me, goals and daily metrics are the key to keeping me focused. If I don’t have access to the right stats, every day, it is so easy for me to move on mentally to the next thing. But if I have quick access to key metrics every day, my creativity stays within certain bounds–my ideas all center on how to achieve our goals.” Paul Allen

My last series has led to a couple of interesting questions regarding what metrics a business owner should  follow closely to keep an eye on how well or badly the business is performing. Without access to these important facts and figures on a regular basis, the business owner tends to lose sight of the end goal and gets caught up in the daily grind of running the business. Unfortunately this leads to situations which the business may not be prepared for and can severely cripple business growth. Metrics are key tools to help give the entire team a dashboard view of how well the business is doing in comparison to the what they set out to do. Metrics can be split up into two segments, financial and non-financial. Focusing solely on just one of them will create several blind spots for the business owner.

When looking at a business, several key metrics come to mind, such as revenue, profitability, growth, customer acquisition and even customer satisfaction. Each one of these tell a story of how the business is performing in various segments. The important aspect of evaluating metrics is paying attention to the right ones. Depending on the structure of your business and the industry you are in, certain metrics will have greater weightage as compared to others. For example if you run a restaurant, customer satisfaction, table turnaround time and margins are critical metrics which need to be looked at on a regular basis. It is when we become distracted or complacent about the current situation that problems begin the creep up.

In light of this I have decided to do a two part series. The first part is going to be focused on financial metrics for businesses. I am going to select five key financial metrics which I believe are critical to most organizations. The next part of the series will be based on five key non-financial metrics that every business owner should keep a keen eye on. Systems need to be put into place to tabulate these metrics and processes outlined to make sure that they are reviewed on a regular basis. This will help business owners to see just how “well” they are actually doing. In some cases the metrics will not be directly applicable to your business model. I will be more than happy to advise business owners about varied business models in metrics that they should be evaluating for their models.