Financial Metrics Every Startup Should Understand
The process of starting and growing a business can be both challenging and exciting. Between the day-to-day management of your business and trying to attract new customers, chances are that you do not review the financial aspects of your business as frequently as you should. Understanding and reviewing a few basic financial metrics, however, can help you to gain more insight into the financial health of your business and spot problems before they become too severe. While attracting new customers is important, the best way to grow your business without incurring additional financial risks lies in organizing and understanding a few key financial components. Remember, accounting is for not only bookkeepers and CPAs. If you own a business or you are thinking of starting one, you owe it to yourself to learn about introductory financial accounting.
How you define your business’ success is somewhat of an individual matter, but there are a few financial metrics that can assist you in understanding the success of your business and how you stack up against the competition. Once you have a solid grasp of these parameters, you will be better able to understand what your company’s profits actually mean and be better prepared to protect your business against unforeseen challenges, including potential market shifts. One of the most common problems that many business owners encounter in analyzing financial data is that it can often seem like complicated formulas. Once you develop a basic understanding of those numbers, you will come to realize that it is actually fairly straightforward.
Cash Reserve Burn
One of the first financial metrics that you need to ensure you are tracking is the rate at which you are going through your cash reserves. Lean finance for startups is absolutely essential. You must know how quickly you are both spending your cash reserves and how quickly you are building them. Every business experiences a dry spell from time to time. Without cash reserves, the future of your business is at risk. If you are not tracking the rate at which you are either building or burning cash reserves, there is a good chance that your startup will run out of cash before it even gets off the ground.
What is Your Runway?
Along with determining how quickly you are burning or building cash reserves, you also need to know how much time you have before you will run out of cash. This is often referred to as the runway, and while it has nothing to do with high fashion or air travel, it will tell you how close you are to depleting your cash reserves. To determine this financial metric, simply divide your business’ cash dividend by the net loss. Understanding how quickly you are building or burning cash reserves is just one of the basics of finance and accounting for startups that should be understood.
Identifying milestones is essential for the health and growth of any business. Whether it is expanding a product line, hiring new team members, or expanding to a new location, any solid business plan should include future goals and milestones. Such milestones are crucial, but in order to accomplish such goals, your business must be able to fund them. Take the time to find out how much funding you will need in order to accomplish those goals. This metric is known as milestone financing.
Accounts Receivable and Accounts Payable
Along with planning for the future, you also need to concentrate on what is taking place in the here and now with your business. This means monitoring accounts receivable and accounts payable. Accounts receivable, or AR, refers to outstanding invoices. If you are not monitoring how long it takes before your company’s invoices are paid, you are not able to accurately monitor your business’ cash flow.
At the same time, you need to understand whether you are adequately managing your accounts payable. While it is always a good idea to ensure that you are paying your company’s bills on time, if you pay too quickly, you could also put your cash flow at risk. For instance, if your clients take an average of 60 days to pay and you are paying your bills on a 30-day cycle when you actually have 60 days to pay them, this could create a problem. It is essential that you have a solid understanding of what it going out as well as what is coming in. Payables should always be balanced in accordance with cash-in flow and existing cash. If you do not have a solid idea of your payables compared to your incoming cash, it can be easy to overspend and put your business at risk. Taking an Introduction to Small Business Accounting course can help you to develop a better understanding of Accounts Payable and Receivable.
Accounts Payable and Receivable Days
Similar to these financial metrics are accounts receivable days and accounts payable days. Accounts payable days is figured by accounts payable divided by the cost of goods sold, then multiplied by 365 days. Accounts payable ratios typically vary according to industry, but generally speaking, you should aim for as high a number as possible.
Accounts receivable days is figured in a similar manner. Divide accounts receivable by sales and then multiply by 365 days. As opposed to accounts payable days, in which a higher number is better, with accounts receivable days, you should aim for a lower number. Keep in mind that this will also vary according to industry. This can be particularly true if your company is involved in an industry in which it is routine to provide clients with a 30-day grace period for payments. For example, a construction company might have an average accounts receivable days ratio of 60+, while a retail store might have an average accounts receivable days ratio of 20. Due to the discrepancy that can exist between various industries, it is important to ensure that you have accurate data for benchmarking your company. This type of information can often be researched through surveys and industry trade groups. Be aware that geographic location can also have an effect due to the fact that business conditions can often vary significantly between different areas of the country.
Understanding accounts payable and receivable are two of the essentials of operating a successful business. Learning these financial metrics as part of the basics of business finance can help you to put your business on the path to success.
Measuring Gross Profit Margin Ratio
Naturally, you also need to be concerned about your profit margin. Some entrepreneurs make the mistake of measuring only how much money they are bringing in without considering the cost of goods sold. Your net profit margin ratio is important, but so is your gross profit margin ratio. To determine this ratio, you need to deduct the cost of goods from the revenue your business earns.
Working Capital Ratio
All businesses need to be concerned with their cash flow, including the amount of working capital they have at any given time. Your company’s working capital ratio is based on current assets divided by current liabilities. Keep in mind that for this calculation, assets are considered to be anything that your company can liquidate into cash within the next year. Liabilities are those debts that will come due within the year. Your company’s working capital ratio is important because it allows you to see whether your assets are sufficient enough to cover projected debts. The goal here is a positive number that is higher than one.
Return on Investment
Return on investment is another important financial metric that your company should be tracking. Whether it is embarking on a new marketing campaign or purchasing new equipment, ROI should always be calculated before taking any new initiative. If you are not able to earn enough of a percentage back on your investment, you will need to reconsider that move and possibly even scale back. Learning the basics of business finance can help you to manage your business so that it performs better.
Customer Acquisition Cost
Every new company understands the importance of bringing in new customers. After all, this is the lifeblood of your business. Even so, it is important to make sure you understand and track how much it costs your company to bring in each new customer. This is referred to as customer acquisition cost, or CAC. For instance, you need to determine your company’s conversion rate and how much it costs to make the most of conversions, and ensure that your company is growing at a healthy rate. The problem that many new entrepreneurs encounter is that they are so focused on operating their new business, they feel as though they do not have time to learn accounting, understand business metrics and handle day to-to-day business.
Depending on the type of business that you operate and the industry in which you are involved, there may be other financial metrics that should be measured and tracked, as well. Other such metrics might include direct margin percentage, sales funnel figures, etc. The metrics listed above will provide your company with a solid foundation for beginning a tracking system that will allow you to develop a solid understanding of your company’s financial health. If you are interested in learning more about financial metrics, sign up for a course on finance and accounting for startups. Entrepreneurs who feel pressed for time may find that a quick finance boot camp can help them to get up to speed and learn how to develop a meaningful financial model with solid metrics that will help them to succeed.
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