Six key ways to measure your financial temperature
Wednesday, June 1, 2011/
If you are serious about growing your business and improving profitability then there are six financial measures that all start-ups should know.
These measures not only help you better understand the current position and performance of the business, but more importantly, are planning tools for developing very focused growth and profit improvement strategies.
1. Growth equation
If there is one formula that every start-up should know, it’s the growth equation.
The growth equation recognises that there are only three ways to grow the revenue of any business:
- Increase the number of customers.
- Increase the number of times they buy from you.
- Increase the average purchase value of each transaction.
Put another way, the revenue of any business can be calculated as follows:
Revenue = Number of customers X Number of times on average each customer buys from you X Average transaction value
Start-ups should have strategies to grow and improve each of the elements of the calculation.
For example, to grow the number of customers, businesses need strategies to generate new leads, improve conversion rates of leads to new customers, as well as strategies to improve retention rates of existing customers.
This simple but powerful calculation is a great planning tool that can be used to forecast the outcome of these strategies.
Some other measures you should be on top of when developing these strategies are:
- The lifetime value of a customer.
- The allowable acquisition cost of a customer.
2. Cash to cash cycle
Without cash a business won’t survive, let alone grow. The cash to cash cycle helps businesses understand how long on average it takes in days for cash to flow through the business.
The longer the cycle, the greater the need for additional funds. The shorter the cycle, the more frequently it can be repeated to generate more income and profit and reduce the need for working capital.
Start-up businesses often have a limited capacity to access additional funds, therefore managing cash by understanding the cycle is critically important.
Once businesses calculate their current cycle, they should put in place actions to shorten each stage.
3. Profit margins
Profit margins are the key profitability measures that every business should know by product lines and by key customers.
Gross profit margin is the dollar amount (often expressed as a percentage) that you make on each sale before taking into account the fixed costs of the business. Fixed costs include expenses such as office rental, marketing and administration staff wages.
The margin is calculated by deducting the variable costs of delivering your product or service from the sale price you charge.
Variable costs are ones that rise and fall based on how much revenue you have, such as purchasing raw goods and delivering the product to the customer.
High margin businesses are typically easier to grow than low margin businesses, as they can be more easily scaled operationally and financially.
They don’t need to find large amounts of cash to invest in producing or selling more of their existing product and they can typically spend more on customer acquisition.
Low margin businesses will generally have less cash to invest back into the business and will need to manage cashflow carefully or source external funds to finance growth.
Another important margin to be aware of in your business is operating profit margin. Operating profit margin is the gross margin minus all operating costs, including fixed costs.