In a meeting recently, a successful serial entrepreneur, who wants to shift to becoming a full-time investor, remarked that they were going back to school to get an MBA at the age of 45. I asked, why? The answer was surprising to me. Even though this entrepreneur had built several companies (north of $50 million in annual revenue) they felt inadequate as a potential investor. Specifically, they cited an inability to read company financial statements, including a balance sheet, etc. in order to determine a company’s health and value.
This made me stop and think. How many other entrepreneurs or small business owners really understand how to read and utilize financial statements or even critical finance metrics in order to determine a company’s health and financial worth? In my career of building a $1 billion company and managing four company turnarounds, I found the following financial metrics below to be invaluable in terms of understanding the business health, let alone potential value. They are simple yet powerful “key performance indicators”, or KPI’s as we called them. Every business owner needs to know the financial metrics below to run a successful business, let alone invest in one.
Real Revenue: While most people think sales is revenue, revenue by my definition is money received in hand. If you sell something and don’t get paid right away, it can create the illusion that everything is fine, but cash flow is king and without it, you will go out of business.
Gross Margin: Surprisingly, quite a few small business owners don’t exactly know what the gross margin is for their products and services. Here is the definition: Gross margin is a company’s net sales revenue minus its cost of goods sold (COGS). In other words, it is the sales revenue a company retains after incurring the direct costs associated with producing the goods it sells and the services it provides. You want this number to be above 50% if at all possible.
Real Profit: This is not the amount of money you think you made but the actual real dollars made after all expenses and taxes are paid. When looking at a company’s expenses, make sure the entrepreneur/small business owner is not mixing personal expenses into their business expenses (e.g. car payments, house payments, etc.) to purposely lower the net profit and tax liability. While potentially good for the entrepreneur/small business owner, it distorts the true profit of the company.
Cash Flow is King: You can be doing $1 million a month in sales and go bankrupt. If you need to build the product (pay for expenses upfront) and then sell the product through a distribution channel, you will be waiting 60-90 days or longer to get paid. That could be a business model that is unattainable in the long run unless your sales volume is high, you started with a large cash reserve, or your gross margin is so high (75% or higher) that you can afford the delay in actual received revenue. Cash is the fuel that runs your business; do everything you can to maximize cash flow.
Accounts Receivable: This is the money that companies owe you. Often neglected, this is one area of the business it might pay to staff correctly. I once had a small business owner call me on a Friday to tell me they just paid payroll with their credit card. This was a $2.5 million company. Turns out they had several clients that owed them more than $400,000 and were at least 60 days past due. We hired an accounts receivable contractor, offered them a 10% commission payment on any past due bills they could collect in the next 30 days. They were aggressive without being offensive and collected $320,000 within the next 30 days. If you do the work, make sure you have processes in place to get paid. Remember, cash flow is king.
Accounts Payable: The best advice I can give entrepreneurs and small business owners is to not spend any money. Or at the very least, don’t spend any money that you don’t have to. Avoid leases with no out clause, avoid any equipment that you really don’t need, keep the business purposely lean. If there is one seminar entrepreneurs and small business owners should all take, it should be one on negotiation. How well you negotiate could impact the future potential of your business.
Employee Utilization: This is one area most people ignore (unless you are in the people services business) and more entrepreneurs and small business owners should pay attention to. If possible, assign a value of “billable or revenue hours” to your employees and measure the employees’ impact on revenue. By doing this, you might just find out where the most revenue contributions are made and how much revenue you can drive per employee before you have to hire another employee to avoid employee burnout.
By Bernhard Schroeder