This is part 1 of a 5 part series on Money Metrics.
A few weeks ago we covered margins, all flavors and types. Many of you asked whether there are more financial metrics you should be using to make decisions? The answer is absolutely! We’ll cover some this week.
Before we do that, remember that I’m not an accountant and so we won’t cover specific accounting techniques and financial governance. Instead, we’ll focus on tools that help you understand how your decisions affect the flow of cash in your business. Most of these tools focus on effective planning, to make sure your business always stays solvent.
Since we’ll be using these financial analysis tools to plan for the future, remember that the future is always changing. No matter what your projections, always apply a safety factor to account for unforeseen problems that may arise along the way.
Tomorrow we’ll get started by talking about Break-even Analysis, also known as planning for profits!
Money Metrics: Breaking Even
This is part 2 of a 5 part series on Money Metrics.
We briefly touched on Break-even Analysis when we covered Contribution margins. If you remember, the Contribution Margin is the amount of net revenue you generate per product sale (sale price minus COGS). This allows you to calculate how many units you need to sell for that net revenue to cover the fixed costs of your business and, in doing so, break even.
Here is the simple example we spoke about previously:
As you can see, as the number of units sold increase the amount of net revenue increases until it passes the Fixed Costs line, which is the break even point. As long as the business sells more units than the Breakeven point, it will be profitable.
Now, in the real world things are never so simple. Specifically, two factors will complicate your break-even analysis:
- It’s likely that your fixed costs will go up with higher unit volumes. You might need more sales people, more warehouse space or more manufacturing capacity. This means that your Fixed Costs can be a moving target, depending on volume.
- Economies of scale mean that your Contribution Margin may change as your unit volumes increase. Specifically, your COGS should decrease over time because it will be cheaper to manufacture larger quantities of your product!
The result is a Break-Even analysis that looks more like the following:
Note that there is not just one Break Even point, there are two! That is because, in this example, there is a big jump in the fixed costs at a certain volume that exceed the growth in Contribution Margins. Such traps are very important to catch before they happen, as you will be burning through capital when it does.
Money Metrics: Payback Periods
This is part 3 of a 5 part series on Money Metrics.
It’s Payback Time
Yesterday we covered Break-even Analysis, which is one way to understand how much you need to sell for your business to be profitable. Sometimes it is more useful to know when a specific investment will become profitable, and that’s done using a Payback Analysis.
Payback, which is very well-named, refers to when an investment you have made returns the amount you paid for it (break-even). For example, if your Customer Acquisition Cost is $200 and you charge customers $20 per month, it will take 10 months for each customer to payback their cost of acquisition. That 10 months is known as the Payback Period.
That is really simple.
I agree! However, often it’s not very useful to think about every investment individually when considering the payback period. The real question is how the payback period affects your business! The key is to think about the payback period as if it’s a loan you made that you need to wait to be paid back. At first you might make a lot of loans, which means you spend a lot of money, but eventually they will start paying back with interest!
The payback period is an important part of understanding your capital needs. How much capital do you need to invest before you start to see it payback and generate positive cash flow? Going back to our example from above, if you acquire 100 customers a month then you will spend $2,000 per month which you will not get back for 10 months (payback period)!
Even after the first 10 months are up, you will still be net negative on your working capital as you’ve been spending on more customer acquisition during those 10 months. So the time it takes you to being to get to positive cash flow on your payback investment may be much longer.
Your capital balance will look like the following:
Note that are more net negative after Month 3 than Month 1 because you’ve spent a lot of money in those three months that you haven’t yet had paid back. Even after your payback period (month 10) you are still negative because only the first month has paid back! It’s not until Month 19 that enough of your monthly investments have paid back do you become net positive.
Understanding how your payback period affects your total capital requirements is critical to making sure you don’t go out of business before you start to generate more cash than you are spending! Often, companies fail during the period of net negative cash flow due to mistaken calculations and a lack of capital.
The great news, is that once your investment starts to payback the compounding can accelerate quickly. This is true of paying to acquire customers, hiring more staff or investing in new products. So don’t fear the payback period, just make sure you understand it very well.
Money Metrics: Waterfall Projections
This is part 4 of a 5 part series on Money Metrics.
One of the most common activities at any company is financial planning. On a regular basis, most companies will estimate how much revenue they will generate in the foreseeable future and how much they will spend in that same time. Depending on the size and maturity of your business, these might be complex estimates predicting years in advance, or simple projections a few months into the future.
Whatever your method of financial projection, the real question is how good are your projections?
Ummmm… I’m not entirely sure.
I’m here to help! A waterfall analysis is a way of tracking your projections over time and eventually comparing them to reality when the time comes. It’s actually quite simple to do! Once you have your monthly projections done, every month you revisit those projections and see if the current month projection was correct and update future projections as necessary.
The reason it’s called a waterfall is that you line up the changes to your projections over time so that you can see how your projections change and how accurate they were when the time comes. Below is an example of a waterfall projection:
Each row is a projection over time, as set in that month. The row for January shows the initial projections for each upcoming month as they were in January. As you look down each column, you can see that projections change over time. For example, the projections as set in May (i.e., looking across the row labeled “May” for the remaining months) are very different (lower) than they were in January (i.e., looking across row labeled “January” row for the remaining months)!
In this particular example we can see a few different things:
- The initial projections were too high, as they consistently overestimated the actual results.
- It took a few months before the projections were adjusted in light of the lower performance, but even when they were adjusted (Mar, Apr, etc.) they were still too high!
- The end result is that the projection for July made in January was 33% higher than actual July results! Clearly we need to revisit the planning process.
Waterfall projections are a handy tool to use as part of any planning process, financial or otherwise. If you are doing it right, your projections should be getting better over time!
Money Metrics: Return on Investment Analysis
This is part 5 of a 5 part series on Money Metrics.
Return to Sender
We’ve covered a few different techniques to connect your money to your decision making this week. No discussion of money metrics would be complete without covering the all important Return on Investment (ROI)! So, let’s cover that today.
Every business decision you make is really an investment. Perhaps you are investing money in hiring new staff, spending your time on pursuing a new partner (time is money), or spending money on advertising to recruit new customers. Whatever decision you are making, you need to understand if you get a return on that investment. Did that new hire generate more value than the cost of their salary? Was the new partner worth the amount of time it took, which you could have spent elsewhere? Did the advertising you did work?
In some ways ROI is the simplest metric we’ll cover, as it simply asks:
How much did you make from a given investment?
For example, if you hire a salesperson who costs you $60,000/year (an investment) and they bring in $70,000 of new business (net revenue) then there is a positive return on your investment in that person. If that same salesperson only brings in $40,000 of new business (net revenue) then you are losing money on that investment.
It might seem simple, but it can be hard to calculate for a few reasons:
- You make dozens of decisions for your business everyday. It can be hard to judge which returns are attributed to which decisions and properly allocate returns.
- It may take years (or decades, in the case of buildings) for an investment to produce a return. Over that period your business will change and you may lose track of the individual investments.
Because of these reasons, calculating ROI often involves more art than science. It can be abused, fairly easily, to justify questionable decisions and investments, or easily miscalculated. As with many aspects of using data, the hardest part is the people interpreting the data.
The best way to protect yourself against biased ROI calculations is to make sure that whoever is determining the return has no incentive to mislead. If I made an investment and my job is measured by whether it produced a return, I’m more likely to find one in the data! This is one of many reasons that having an independent finance group is so important for larger companies.
We’ve covered a lot of money metrics this week, and I hope you find at least a few of them useful in running and growing your business. Next week we’ll discuss setting goals and how data driven goals can either be a powerful weapon or a horrible burden.