Important Metrics for Small and Mid-Market Companies – Part 1: Basics
This post originally appeared on Medium.
In an average month, my organization explores around 50 companies for possible investment. We review everything from organizational structure, culture, and financial performance, to sales systems, competitive position, and leadership style. This gives us an unusual vantage point from which to recognize patterns of success, and failure.
Getting data is never the problem. In fact for most executives, information can be overwhelming. Getting accurate data and interpreting it appropriately is an entirely different story.
In The Ceiling of Brute Force, we discussed what operational areas impede a company from continued growth. In a series of posts, we’re going to break down 19 of the most important key performance indicators (KPIs), which demonstrate how effectively the business is being run. Think of KPIs as the canaries in your coal mines. If one starts going south, you know it’s time to take a closer look.
Presented in a five-part series, here’s our take on what you should pay attention to, allowing you to focus your time, effort, and dollars. The five parts are: Basics, Customers, Team, Operational Efficiency, and Investment. We’re starting with the essentials in Part 1: market size, cash, and margin.
1. Market Capacity, Share, and Movement
KPI Objective: Know where you are, and then set goals for growing into the position you want within your market.
While most see potential customers everywhere they turn, the shrewd executives know their market and target customers inside-out.
The place to start is market size, or the total amount of money being spent on the goods or services in your field of opportunity. Your market share is your company’s revenue divided by the market size. The calculation is straightforward, but the inputs require considerations. If you’re running a marketing firm in Des Moines, is your market defined as all marketing expenditures in your immediate geographic location, the state, region, U.S., or world? Do you also include revenue for all sales-related products and services, or just consider your specific niche? The answer is situation-dependent and the goal is relevancy. You want to understand the landscape and your position in it.
Ideally market size and your share would grow indefinitely, but dreams only come true in Disney movies. Potential market capacity must take into account customers’ ability and willingness to pay, production costs, competitive trends, and alternatives entering the market. Your potential market share is dependent on the risks you’re willing to take, the investments you’d like to make, and your all-around ability to execute on the strategy as compared to your competitors. Don’t forget that most businesses battle complacency, or the do-it-yourselfers, far more than competitors.
2. Cash Flow, Revenue Predictability, and Credit
KPI Objective: Know how, and at what rate, money enters and exits your company so you can properly assess the risks and rewards of various cash strategies.
Cash flow is like oxygen: irrelevant until it’s the only thing that matters. Since cost structure is almost always more consistent than the revenue side of the equation, most businesses experience varying degrees of cash flow problems. This may seem like a yawn-inducing non-issue, but the ramifications can be dire and extremely expensive.
When cash doesn’t flow, the money necessary to operate the business must come from somewhere. Bank lines of credit, or cash reserves are usually the buffer. But what happens when those are exhausted or non-existent? Most businesses start borrowing from their vendors by not paying them, which leads to price increases, decreased vendor performance, and possibly a service interruption, or termination.
The next step is to turn to friends, family, or a form of business payday lending. The latter unfortunately represents the most likely option for smaller businesses. Typical financing arrangements include high interest rates, fees, and even an option to purchase equity at a deep discount. In the past year, we saw a reputable company paying upwards of 22% to stay alive, a situation they had been in for the past ten years.
Needless to say, staying out of cash flow trouble is highly advised and underappreciated. The best way to do so is to increase the predictability of revenue. Quick-pay discounts, like offering 1–3% for customers who pay early can be effective. Developing a subscription program for a portion of revenue can also greatly increase visibility.
To begin tracking, chart your revenue history, considering both trends and outliers, and use the results to begin forecasting future months and years. Moving forward, rather than simply updating forecasts when new information becomes available, track your actual revenue against the forecasts, and continually question what resulted in variances. Over time, you should be able to better understand how effective forecasting is for your business, which can influence how you manage your balance sheet, hiring and capital expenditures.
Repeat the process for expenses.
3. Gross Margin
KPI Objective: Know, after direct expenses, what percentage of sales is actually available to fund operations (and, hopefully, drop to net profit).
Profitability being the ultimate goal, gross margins can be a stronger indication than total revenues of overall organizational health. Decreasing or comparatively low gross margins can indicate trouble, and high gross margins give you opportunities to screw up a lot without going under.
As a reminder, gross margin is total revenues less costs of goods sold (COGS). If customer pays you $10 for a widget and your manufacturing costs are $8, then your gross margin is $2, or 20%.Think of gross profit as what sticks to the organization and can help pay salaries, rent, etc.
To benchmark your gross margins, it may be worthwhile to find comparable public entities. As actual expenses included under COGS varies by company, break out what you are including so that your gross margin as a percentage of revenue can be properly understood in comparison to other companies (i.e. some track direct labor under COGS, while others do so in operating expenses).
There is no general healthy gross margin range to target. As Amazon’s Jeff Bezos famously said, “Your margin is my opportunity.” There are many highly successful models with relatively low gross margin levels, but it is dependent on knowing your business model (i.e. low-cost wholesaler) and structuring your offerings and operating expenses accordingly.