Small business owners face multiples challenges in managing their finances effectively. A review of Historical Stock Data, for small listed companies (under $10million in market capitalization) reveals there are four critical financial metrics that every small business should monitor closely:
Cash Flow
A positive cash flow is essential for a small business to remain solvent and meet its ongoing obligations. Even a short-term cash shortfall often results in insolvency and permanent closure for a small business – according to a U.S. Bank study, over 80 percent of small business failures are due to poor cash flow management and not a lack of sales. Despite this, many small business owners often focus on revenue or other top-line metrics.
The central issue in cash flow forecasting is that the cash inflows and outflows are usually inconsistent from month to month, resulting in large net cash demands such as when a vendor repayment comes due in a period of low sales (such as February for an ecommerce business). Thus a detailed cash flow forecast is essential to map the cash inflows and outflows and ensure the business has sufficient working capital for the entire year.
Cash Runway
For early-stage businesses which will require additional fundraising before achieving profitability, it is important to forecast the number of months of cash the business has in reserve to ensure that there is sufficient time for fundraising before the business runs out of cash.
Profitability Financial Metrics
While cash flow monitoring is essential to ensure the short-term viability of the business. There are several key profitability ratios which can serve a key gauges of a business’ long term viability:
Gross Profit Margin
Gross Profit Margin is the percentage profit a earned on a sale after paying the costs of providing the product or service. For example, a car dealer that sells a car for $25,000 which they purchased from the manufacturer at $21,000 would have a gross profit on sale of $4000 or a 16% gross profit margin (4000 / 21000).
An often overlooked aspect of gross profit margin is that it tends to persist over the life cycle of the business, so a company that attempts to establish itself by underpricing versus the competition may have difficultly in expanding its gross margin in future.
Net Profit Margin
The net profit is the profitability of the company after accounting for all operating costs such as administrative overheads, marketing, interest expense etc.
The net profit closely corresponds with many small business owners’ concept of profitability, however, it is important to closely monitor the net profit margin (ie the percentage profitability) over time to ensure that costs are not outpacing revenue.
For a mature company, a net margin of 40% or greater is a sign of a very healthy business with a strong brand and pricing power, whereas a margin below 10% is usually a sign of a distressed business that is having to cut prices in order to maintain revenues.
Efficiency Financial Metrics
Efficiency metrics can guide the small business owner on how the different sectors of the business are performing.
Sales Efficiency
Sales efficiency is a benchmark that measures how well a company generates revenue from its sales activities. The sales efficiency ratio (also known as the “Magic Number”) is the amount of revenue earned for a dollar of sales and marketing spend.
The calculation is simply the revenue divided by the sales and marketing spend, although this is sometimes mismatched by several months in recognition of the fact that marketing effort can take some time to manifest as new sales.
Inventory Days
For businesses that maintain inventory, the inventory days metric is an efficiency metric that measures how long it takes a business to generate sales equal to the value of its inventory. The longer products remains in inventory, the more a company’s cash is tied up in working capital (which impacts its cash flow). It can also be an indication that production is too high or sales are slowing.
Customer Financial Metrics
While standard accounting metrics such as profitability and cash flow are important for monitoring a business’s performance, customer-related metrics can provide more granular insights into a business’s growth potential and long-term sustainability. Two essential customer metrics are Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLV).
Customer Acquisition Cost (CAC)
CAC measures the total cost of acquiring a new customer, including marketing and sales expenses. Customer acquisition cost in usually the sales and marketing expense divided by the number of new customers. Typically businesses stagger this calculation since sales and marketing takes time to create new customers. Thus the sales/marketing expense in one period is matched with the new customers in a subsequent period.
Customer Lifetime Value (CLV)
CLV is the total gross profit earned from a customer over the entire span of a customer’s trading with the company. For example, an online publication charging $20 per month where the average subscription period is 8 months will have a CLV of $160.
The CLV needs to be evaluated with reference to the CAC to ensure the business is financially viable. In the above example, a company with a CLV of $160 could not spend over $160 on CAC and would likely be making a long-term operating loss with a CAC over $140.
