256 - Struggling to Make Sense of Your Company's Financial Data? Here Are 5 Key Financial Metrics You Need to Know
Every business has its own set of critical numbers and metrics. If you're a software-as-a-service business, you'll need to know cohorts and total lifetime value. If you're a manufacturing company, you'll be tracking production lead times, quality variances, and raw material costs.
However, regardless of your business model, there is a core set of financial metrics every company should measure and monitor. I use these numbers when I coach leadership teams of high-growth companies. These numbers are based on having worked with dozens of businesses and the common challenges I have seen when they scale quickly.
1. Cost of Sales (percent sales cost per dollar of revenue)
The first question I ask when I see revenues is how much did it cost to create those sales. Why? I want to know what it will likely cost to increase those sales and if it's actually worth it based on the remaining revenue available. This number includes all of your marketing and sales costs. Don't forget to calculate the loaded costs of any staff salaries or contractor expenses.
For example, consider a million dollars in sales that cost $250,000 to produce (25 percent) versus $300,000 in sales that cost $20,000 to produce (6.7 percent). The latter is exciting. The former gives me pause.
2. Gross Profit Margin (gross profit after direct cost of delivery)
Gross profit shows how much revenue is available after you pay for the production and delivery of a product or service. For businesses such as software-as-a-service, this number can be quite large since the incremental costs are minimal. For businesses such as manufacturing, it can be quite small.
Once we calculate the gross profit and track it over time, we can see if the business is getting more (or less) efficient and how it compares to others in the industry and other geographies.
3. Labor Efficiency Ratio (gross profit divided by total direct labor costs)
The labor efficiency ratio (LER) shows us how hot or cold the organization is running and how much production capacity we have remaining from a "people" point of view. You calculate this number by dividing the gross profit (revenue less cost of goods sold) for a given period by the total labor cost (loaded staff and contractors) during that same period.
Over time, you'll see that when that ratio is high, the organization feels busy and maybe even a little frenetic. This tells us we need to hire staff before we increase sales. When the number is low, things are relaxed and people may even have time on their hands. This tells us we have free capacity and we can sell without having to add staff.
4. Accounts Receivable to Revenue Ratio
Most executives pay attention to accounts receivable (AR). However, for a growing company, this can be a dynamic target so I suggest looking at it as a percentage of revenues instead of a total amount. It's much easier to spot trends and future cash concerns when you see the percentages changing rather than trying to interpret the total AR which will naturally grow as the company scales.
5. Cash Reserve to Committed Expenses Ratio
In order to survive the ups and downs in business, you need a cash reserve. Furthermore, this reserve needs to increase as the company gets bigger. If you don't increase this reserve, you're unwittingly increasing financial risk.
Generally, I suggest a company keep three months of committed expenses in reserves. This includes expenses that you cannot easily and quickly cut/reduce in a downturn.
Less than three months means that you'll be under the gun if your sales dip and will be forced to cut deeper than you'd like and make it harder to bounce back easily. If you're stowing away more than this, you're probably keeping too much cash at risk in the company.
Every company will have additional financial metrics based on the industry and stage of business, but these five are the core set that every company needs to know and watch. Having and knowing them well will give the leadership team better data and insight in order to make better decisions more quickly.
Source: Inc.
