Contributed by Shawn Johal, an EO member and former president of EO Montreal, who is a leadership speaker, bestselling author of The Happy Leader, and founder of Elevation Leaders, a business growth practice helping companies 10X their business valuation.
A whopping 77 percent of business owners wished they better understood the numbers within their business, and 82 percent of businesses fail due to cash management problems.
No matter your background, understanding the financial metrics that govern your business can be daunting. I know because I’ve lived it myself.
In our first business, a manufacturer and distributor of LED lighting solutions, we were committed to growth: we implemented the Scaling Up methodology and grew very quickly over twelve months.
Things were going great—until we realized there were key numbers that our business depended upon, which were not optimized. We didn’t know “which numbers” we needed to work on, so we tried them all. We systematically reviewed every financial and operational metric within our business until things began improving.
What I learned in the process: Profitable growth is entirely achievable for every company, and as entrepreneurs, we don’t need to know every number inside out. Four key financial metrics will contribute to major positive transformation within your company—learn, optimize and retain a bird’s eye view on them, and the sky is your limit!
Here they are:
1. Cash flow
Cash flow: The change in deposits plus the change in debt in your company.
It’s the first— and most important—metric to understand. In simpler terms, it’s the net balance of cash moving in and out of the business at a specific point in time. Many common business transactions fall into and affect cash flow. Purchasing inventory from suppliers and paying wages to employees count as cash moving out, whilst selling merchandise to customers and monthly subscriptions or monthly payment installments from customers count as cash moving in.
Cash flow is simple, but don’t let its simplicity undermine its importance: I’ve met too many companies that fly or fail entirely because of cash flow. Keep an eye on it at all times!
2. Operating profit
Operating profit: Gross margins subtracted by overhead costs in your company.
In my view, operating profit is the second most important financial metric to monitor. It helps a business understand the net profit the business is making from normal business operations.
This metric excludes negative variables such as tax payments or interest payments on debt. Instead, contrary to cash flow, it includes positive variables that are outside of the core products or services the business offers to the market. A profitable business has a positive operating profit, and also has a sustainable plan to keep it that way. Sometimes, this metric is also referred to as EBIT (Earnings Before Interest and Taxes).
The main purpose: Operating profit helps entrepreneurs, investors and leadership teams know how profitably the business itself is operating.
3. Working capital
Working capital: Receivables plus inventory minus payables.
Calculating your working capital will help you understand how much money is available to meet your business’ immediate and short-term obligations.
If your company does not have inventory, then the calculation is simply receivables minus payables. Obligations like paying off short-term expenses and debts require working capital. Positive working capital indicates that a company is able to sustainably support day-to-day operations, while simultaneously paying off debts or expenses the business accrues.
Working capital becomes particularly key if, for example, your business is a seasonal one: you’ll need more working capital available to operate in specific busy months of the year or to stay afloat during slower seasons. Working capital may also need an injection if, for example, you’re looking to take advantage of bulk discount purchasing from a key supplier.
Having a grasp on and being able to project your working capital becomes key in tons of scenarios that real entrepreneurs face each day. Keep your finger on its pulse.
4. Labor Efficiency Ratio (LER)
LER: The Labor Efficiency Ratio within your organization.
The fourth—and most difficult—metric to calculate. Many see this as an execution metric, but it truly is a financial metric. Labor efficiency ratio will not only directly impact profitability, but it may ultimately be the No. 1 driver of profitability within your company.
LER measures the productivity of people within your business. To calculate this, you take the expected direct labor hours of actual output, divide it by actual direct labor hours worked, and multiply it by 100%. A ratio above 100% indicates greater labor efficiency than budgeted and vice versa. Remaining efficient within a business is huge, but this metric is often ignored in comparison to profit and cash flow.
LER matters because very few (almost none) companies scale with a single person; our businesses need to hire in order to grow profitably. LER measures the productivity of each dollar spent on labor: it gives you a clear picture of how much your business is investing in labor and what the “return” on that labor really is.
Having a clear picture of your company’s LER will help you make key strategic decisions that will have a major impact.
As a business growth coach, I regularly meet entrepreneurs who (no matter how seasoned and smart they are) only review their financials once a year. Sometimes the reason is there’s a disconnect between understanding these numbers in a clear and easy way; sometimes, it’s because they feel overwhelmed by the numbers.
If you can’t envision yourself reading these key metrics each week, then ask these questions and make sure you get clear answers to them:
- Is there enough money to continue operating while paying for debts?
- Do we have a positive cash flow that can cover paying employees and bringing in inventory?
- Is the operating profit high enough to allow the business to continue to grow?
Yvon Chouinard, founder of Patagonia, has an amazing quote I love: “Profit is what happens when you do everything else right.” Aside from bringing us genuine happiness, our businesses exist to grow profitably. Monitor these few metrics closely, and profit will come, I promise!
For more insights and inspiration from today’s leading entrepreneurs, check out EO on Inc. and more articles from the EO blog.
Categories: Best Practices FINANCES