If you want success in business you need to know your numbers. It falls into a leadership strategy that I call ‘Delegate and Check’. This means that you can delegate or outsource to someone who is way better at this than you are.
But you need to check over their work to make sure things add up. I have heard so many business owners tell me stories about how they had trusted their accountant for years only to find they had been skimming the business for years.
It’s a cruel world out there and some people will take advantage of you if the opportunity presents itself. Education is your best weapon. Below are the 7 critical numbers business owners need to know.
It may sound obvious but this number is so important. In fact it’s pretty much the first thing that investors ask on Shark Tank. ‘How much does it cost to make and how much are you selling it for?’
It gives insight into how efficiently a business can utilise its resources and get a return. So for example if you it costs you $0.50c to make something and you sell it for $1 there is not a lot of room for a profit after you add in other costs such as rent, marketing etc.
The other thing that gross profit will reveal is what part of the business type matrix does the business fall under. There are 4 possible categories.
Low Cost/Low Sales
This is when a business has very niche or premium product. Rolex is a great example. A Rolex may sell for $10,000, however there is only $750 worth of costs in the watch. To reach $1m in gross profit the business would have to sell only 108 watches with a Gross Profit of $9,250 per watch
Low Cost/High Sales
A number of businesses can fit into this category but I’ve decided to go with Google. It costs very little for Google to sell AdWords. You can set it up yourself with no labour costs required. Let’s assume that Google makes $50 per ad campaign. Google would need to make 20,000 sales to reach $1m in gross profit.
High Cost/Low Sales
Whilst this may sound like the worse business type it can actually be very profitable. However to make it work the business has to be selling bug ticket items. Home loan providers fall into this category. Home loans have very small margins.
The financial institute will borrow the money form the Reserve or Central Bank for say 2% and lend it out to customers at 3%. This leaves a margin of only 1%. Assuming that the average mortgage is $400,000 and the gross profit is 1%, the business would need to make 250 sales to reach $1m.
High Cost/High Sales
The first industry that comes to mind is the food industry. A burger may have $3 worth of product and sell for let’s say $6. The business would need to sell a bit more than 330,000 burgers to achieve a gross profit of $1m.
Whilst in any case high sales is good regardless of the product and its costs this highlights the strategy that needs to be executed to run a minimum viable business. If you need high sales to be viable then the company will need extensive distribution networks to hit critical mass. However lower sales means that the business is targeting a more specific type of customer.
Whilst the knowing the gross profit is essential, operating expenses gives even more information about the business. Generally speaking there are five ways to improve the possibility of a business. By cutting costs, increasing sales, having a current product in a new market, a new product in the current market or a new product in a new market. This can be answered by looking at the operating expenses.
The above income statement is for Amazon. It shows that Amazon fits into the High Cost High sales category. For every product they sell for $1, $0.67c goes towards the cost of producing the product.
Net profit shows that for every $1 of sales the company is actually making only half a cent! Given the nature of Amazon and what it sells, reducing the cost of revenue is unlikely. As a percentage basis sales and general admin has increased in the past 4 years but at a slower rate of sales.
Increasing efficiency with operating expenses appears to be one of the main ways in which Amazon can approve their performance.
Again obvious but critical. The net profit provides the complete picture of the business. When looking at the income statement from Amazon we see that revenue is $107bn.
A net profit of only $596m immediately shows that this business has some serious expenses and needs to be achieving critical mass all the time. To provide an alternative perspective on the company.
Based on the above information if Amazon only achieved $1bn in sales (a great achievement for most companies) the net profit would only be $5m.
The other reason that net profit is a critical number to know is it gives good insight into the valuation of the business. Or how much your business is worth.
There are two types of businesses. A business that is a job for the owner and business that can run independently of the owner. A business that is a job for the owner can be found when they are the owner operator.
This means that they manage the day to day running of the business plus the high level strategic aspect of the business as well. A business that can run independently of the owner means the owner has put in management to run the day to day side of things and they focus on the higher level business decisions.
It goes without saying that a business that operates independently of the owner is more valuable. That’s because of anything happens to the owner or the entrepreneur the business will also be impacted. It is possible for a business to outlive its founder. Think of Ford and Apple.
The most common way to value a business is by using multipliers. It’s a task of simply multiply the net profit of a business by a number to reach a valuation. Most businesses will know their net profit so it is a matter of finding the most appropriate multiplying number to use. To get a value of 10x net profit you need the following attributes
- Strong cash-flow
- Growing revenue
- Multiple Revenue Streams
- Operational Systems
- Up to date financial recording and management
- Repeat Customers
- Strong brand presence
- A business model that can be replicated
So if your business meets the criteria above and generates $1m a year in profit, it can be reasonable to value your business at $10m.
There are companies that are pre-revenue that get funded and valued. This is because the founder has been able to sell the future of the company. There used to be a saying ‘get 10,000 users and sell to Microsoft’.
The logic of that strategy is that Micorsoft can make more money from the users than the original business. The other condition of raising pre-revenue capital is how unique the business is and how much competition is around.
The reason that you want to take on investors is to get support in creating a higher multiple for your business. You may apply for funding and have business that is valued at 2 times profit. But an investor can help put strategies into place that gets you a valuation of 8 times profit!
Debt to equity ratio
The debt to equity ratio provides a number that give insight into the current performance of a business as well as future performance. The D/E ratio shows how much debt the company has compared to how equity the company has.
A business is seen as more risky when they have a higher amount of debt. This because paying back the debt is a priority. A business will need to service a loan and payback debt before it can pay dividends (or a wage for a small business owner) or before the revenue can be used to reinvested to grow the business. The calculation is as follows
Total liabilities/Total Equity.
Let’s say that you want to buy a local coffee shop that costs $100,000. You put in $50,000 of your own money (equity) and borrow $50,000 from the bank (debt). Your debt to equity ratio would = 1:1 A general rule of thumb is to keep the ratio to 2:1.
Using the same coffee shop example but this time you only have $20,000 to put towards the purchase so you need to borrow $80,000. The new ratio is 4:1. Meaning for every dollar of debt the business only has 25c to cover it.
So if the business collapsed and the bank wanted their money you wouldn’t have enough equity to cover the loan. The other challenge is that whilst you have an $80,000 loan you would be paying back say $10,000 per year.
If you didn’t have that loan you could be using that $10,000 to buy more equipment, build the business, pay a casual staff member or even give yourself a higher wage! It’s also something that investors look at closely as they do not want to be buying into a business that is paying someone else’s debt.
In fact it’s common for an investor to say they will only invest once the business had paid down its debt.
However the above examples are only used when starting a business. Another spin on the D/E ratio is looking to grow the business.
Example. 2 years ago you bought a coffee shop for $100,000. You put in $50,000 cash and borrowed $50,000 meaning your D/E ratio is 1:1. There is another coffee shop that is for sale for $100,000. You get an extended loan for $100,000 to make the acquisition. Your D/E ratio is now 3:1.
Positive – The new coffee shop is very profitable and makes enough money to service the $150,000 loan plus fund its operations.
Negative – The new coffee shop underperforms and needs a cash injection from the first business putting both at risk
If taking on debt to expand ensure that the returns outweigh the cost of debt.
Value of a customer
By this I mean what is each individual customer going to spend at your business each month/year or even lifetime? When first starting a business this number can be reached through some market research and assumptions.
But as your business grows you should be able to pinpoint through consumer behaviour exactly how much customers are spending in your business. Some businesses will be easier than others.
Example. You are opening up a new gym. You are selling annual memberships for $600 that are paid monthly. You may also assume that during the year the average gym goer will spend $300 on personal training sessions and maybe $50 in drinks or snacks from the vending machine.
Adding all this up shows that the annual value of your customer is $950 per year. After a few years you will be able to calculate the lifetime value of the customer based on length of gym membership and spending habits.
This number now allows you to calculate the breakeven point in your business. Say the gym has a total of $300,000 worth of expenses every year. By knowing the value of your customer you know that you would need at least 316 (300,000/950) members to break even.
If you wanted to pay yourself a wage of $150,000 per year (total expenses now being $450,000) you would need to acquire 474 customers in total. Now you can start to see if your business model is viable. Is the market big enough?
Is your gym big enough for that many people? Added note apparently only 20% of gym members regularly attend the gym.
Cost of acquiring your customer
Once you know the value of your customer you know how much you can spend acquiring them. Going with the above gym example again let’s say you undertake a marketing campaign and spend $10,000 on advertising and sponsorship.
From this you generate 20 new customers who sign up as members. Your cost of acquiring a customer for this campaign is $500 (10,000/20). You know that each customer will spend $950 per year in your business so this has been a successful campaign.
Essentially you have spent $10,000 for $19,000 in revenue. And this is now the essence of your business model. You don’t have to worry so much about allocating a sales or marketing budget because you know that for every $500 you spend you will acquire a customer who will generate $950 in revenue.