CMYK
FINANCIAL HEADLINE NEWS & ANALYSIS
15
small biz
finchannel.com | 19 august, 2013
entrepreneur
Most Important Metrics
Ralph Burleson,
GeoCapital
O
ther
possible
titles:
“Three Numbers That
Mean
The
World,”
“Three Numbers That
Can Kill Your Business
(Or Make It Thrive),” “Of Money
And Metrics: Three Numbers Every
Business Owner Should Know”
Last week’s column focused on
how to help your company survive
its first disaster. A key component
of survival is having enough free
cash to deal with disaster. This
week, we are going to look at how
to track your cash, using the three
important numbers that all businesses need to continually monitor. The numbers are cash burn,
net profit, and cash flow, and if you
know what these numbers are and
where they will be in the future, you
can predict the success (or failure)
of almost any business. For large
companies, these three metrics, or
measurements, are the most important factors affecting stock prices.
Reviewing these numbers for your
business every single day will focus
your thinking and help you make
the critical decisions that lead you
to success.
Metric One – Cash Burn Actual / Cash Burn Planned. “Cash
burn” describes the difference
between how much money you
planned to spend and how much
you actually spent, and tracking
it is critical when you are building
your business infrastructure. Every
entrepreneur should have a plan,
whether starting a business, opening a second location, or investing
in some other business expansion.
That plan should include cost information for each of the elements of
business infrastructure needed to
begin operations.
Some small business owners
might have their plans written on a
piece of paper. Some might have it
in the computer in Word or Excel.
Some might have projections documented in a formal business plan,
while very small entrepreneurs
might just carry lists of things they
need to do and buy in their heads.
No matter how sophisticated or
basic your planning process, you
can still track cash burn. Add up
all of the money you have spent,
whether you planned to spend it or
not. We will call this number “actual expenses.” Next, add up the
money you planned to spend on the
items you have already purchased.
Do not include items that you still
need to buy. Do not include items
that you forgot to include in your
original plan. We will call this second number “planned expenses.”
Finally, divide actual expenses by
planned expenses to find your cash
burn ratio.
If the result is over 1.0, you are
spending money faster than you expected. Without extra cash reserves,
you will run out of money. You
should consider finding additional
funding or altering your plan to reduce your initial cash outlay.
If your result is less than 1.0, you
are spending money more slowly
than expected. This is a good place
to be, because it means you should
have extra cash left over for future
needs.
Let’s explore a simple example:
Irakli, a 14 year old boy, decides he
wants to start an on-street car wash
business. He needs to find a bucket,
a bottle of soap, a tire scrubber, and
10 towels. He comes up with a budget of 40 lari to start up his business.
His uncle loans him the money and
Irakli goes to the market.
At the market, Irakli’s friend tells
him that he needs THREE buckets
instead of the ONE in his original
plan: one to carry things, a second for clean water, and a third
for soapy, dirty water. Irakli thinks
about the suggestion and decides
his friend is right. He buys three
buckets and the bottle of soap as
his first purchases. Having just read
this column, he decides to check his
cash burn ratio. He had planned to
spend 10 lari for a bucket and 5 lari
for soap, for a total of 15 lari. Instead, he spent 35 lari, giving him
a cash burn ratio of 2,3 (35/15). He
knows that he is spending money
much too quickly and must change
his plan or get more cash. He decides to secretly use his mother’s
towels instead of buying them at
the market, and he asks his friend
for an extra 5 lari to help buy the
tire scrubber. He comes up with the
physical things he needs to open his
business.
Irakli’s example was very simple, and he really didn’t need cash
burn ratio to tell him he didn’t have
enough cash. However, when a plan
becomes even a bit more complicated, it is very easy to miss important
items and overspend. From NASA
going to Mars to Trump building a
new casino, almost everyone misses
estimates. It is important to track
your cash burn because this metric
will warn you in advance of a coming cash shortage.
Metric Two – Net Profit. Net
profit is the difference between the
price a business sells something for
and what it costs them to provide it.
There is no better predictor of business success than a business’s profit
trend. Even the smallest company
MUST track their profit per sale and
their total profit for each month. Go
to Google and look up examples of
income statements or profit and loss
statements for small businesses.
As you will see from the examples:
Profit = Sale Price - (Sale Cost +
Other Expenses). You need to track
this information every month. Let’s
turn again to Irakli for an example
of how to calculate profit.
Irakli charges 7 lari per car. This
is his sale price. He has direct costs
for soap, and for towel washing and
wear reserves. These direct costs
total 1 lari per car. He also pays a
local lady 10 lari a month to use her
water and spends 2 lari per day on
transportation to get from home to
work and back. He washes on average five cars per day and works 20
days a month.
Irakli’s per car gross profit is
6 lari (7 lari sale – 1 lari soap and
towel expense). Every month Irakli
makes 600 lari in gross profit (6 lari
per car x 5 cars x 20 days). However, he still has to deduct his monthly
expenses of 10 lari for the water and
40 lari for bus rides leaving him
with 550 lari net profit (600 – (10
+ 40)).
After a single month in business,
he will make enough money to pay
back his uncle and buy his mother a
new set of nice new towels.
Now, though, Irakli is not satisfied with his 550 per month net
profit. Because he read this column,
he decides to use math to make even
more money. He tests another car
washing location on the other side
of the city, two hours away from his
house by bus. In this new location
he can charge 10 lari per wash, but
he only has enough time to wash 4
cars per day because he has to travel
back and forth from home to work.
Based on the math, did he decide
to move locations? What would
happen to his monthly profit if he
decided to take a taxi to work every day, giving him enough time to
wash 6 cars, but costing him 18 lari
a day for the round trip? If you had
Irakli’s business, what would you
decide to do?
Net profit is the most important
metric a small business own can
track. It is critical to know how to
calculate net profit and understand
the factors that contribute to it.
Look at the Google examples and
write out your own income statement. If you haven’t opened your
company yet, estimate what the
numbers should be, then compare
those estimates to the actual numbers are after you start operations.
Metric Three – Cash Flow.
Cash flow is essentially the change
in available cash a company has
from one day to the next. Neglecting this third critical metric has
killed many otherwise successful
companies. Many small businesses
begin operations with cash on delivery, or COD, terms. In other words,
when they buy things, they pay for
them immediately. When they sell
things, they are paid immediately.
Sometimes, however, there is a delay between when a business needs
to purchase something and when
they can sell it.
Imagine, for example, a small
furniture maker. This manufacturer
must buy wood and other raw materials to build the furniture before
they can deliver it to a customer
and collect payment. If the furniture maker accepts a large order,
they might not have enough cash on
hand to buy raw materials for the
project. What happens to the manufacturer if they pull together all of
their available cash for materials
and complete the order, but then
their customer pays two weeks late?
The company will not be able to
take any new work, because they
don’t have cash for materials. Too
many late paying customers can kill
a new business.
Let’s go back to Irakli for a moment. Imagine that a local company
asks him to wash their fleet of 25
cars, twice a month, for a total of 50
washes. He can’t do the work himself, so offers his friend a part time
job. Irakli will give his friend all of
the supplies necessary and pay him
4 lari per car. He agrees to pay his
friend once every week.
The company, however, asks
Irakli to give them an invoice and
will only pay him once per month,
30 days after he submits his invoice.
Even though Irakli is making 5
lari per wash, yielding an extra 250
lari per month in net profit, he still
must come up with enough cash
pay his friend and buy supplies
for 60 days. Irakli needs 500 lari
in cash, just to take the company’s
business.
Thinking about cash flow is critical for all companies, and managing
it well can be the difference between
life and death for new businesses.
Conclusion – Track the Trends.
The metrics above are critical to
monitor when starting any new
business. What is even more powerful and often overlooked by small
business owners is something called
trend analysis. Tracking a trend is
as easy as comparing the values of
one metric at two different points
in time. Every mother in the world
has done trend analysis with her
child’s fever. When Irakli was sick
as a child, his mother noticed that
at 21:00 his temperature was 38 degrees Celsius. Later that evening, at
23:40, it was 40. His temperature
was trending up and she was worried. A few hours later, his temperature had come down to 39 degrees
and she felt relieved. She was relieved because the temperature was
trending in a good direction.
Trends in business are the same
as trends in temperature. Looking
at the trends of your three most important metrics provides valuable
information about the actual health
of your new business. In many cases, trends in metrics like net profit
are more important than actual the
numbers themselves.
Would you rather own Market A
with a 5.000 lari monthly net profit or Market B with a monthly net
profit of 8.000? Most people would
pick Market B making 8.000 lari
per month.
Imagine, though, that you saw a
profit trend where Market A, now
making 5.000 lari a month, was
only making 1.000 per month a
year ago. Assume that the trend was
consistent, with profit increasing
incrementally each month during
the past year.
Now imagine that you also saw a
trend where Market B was making
9.000 lari per month last year and
their profit has been slowly decreasing each month.
Which market would you rather
own now?
Understanding
metrics
and
trends is critical to success in any
new business. Analyzing these important metrics is not complicated
and can be tackled by anyone with
basic math skills. Knowing the
trends in these numbers will help
you make better decisions that ensure your success.