Profit and revenue tell you a lot--but they don't tell you everything about the health of your business.
Every business focuses on and measures revenue. Every business focuses on profit and loss.
And they should, but there are a few other financial and performance measurements that can provide earlier warning signs of trouble—or early indications of longer-term success.
Here are four metrics your business can’t afford to ignore:
Cost to Acquire Customers (CAC). Also known as customer acquisition cost, this measures the cost of landing a customer. In simple terms, add up the cost of marketing and sales—including salaries and overhead—and divide by the number of customers you land during a specific time frame.
Spend $100 and acquire 10 customers and your CAC is $10.
What’s a good number? That depends on your industry and business model. It’s also important to understand how CAC fits into your overall operating budget. The leaner your operation the more you can afford to spend to acquire a customer.
Also keep in mind that a high CAC makes sense if you also generate a high…
Lifetime Value of a Customer (LTV). Unless your business is truly one-off, some percentage of customers will become repeat customers. The more repeat customers you have, and the more those customers spend, the higher CAC you can afford. (Some business models are built on breaking even on the customer’s first purchase; future purchases will be profitable since the CAC is at or near zero.)
LTV is often tricky to calculate and does involve making a few assumptions, at least during the startup phase. But once you’ve built a little history you can start to spot customer retention and spending trends. Then the math gets a lot easier: Determine what the average customer spends over a specific time period and calculate the return on your original CAC investment. Sense-check that against your profit and loss statement. Roughly speaking, the greater the LTV, the higher CAC you can afford.
Why do these two metrics matter so much? A rising CAC means you’ll need to start cutting costs or raising prices—or do a better job in marketing and sales. A falling LTV indicates the same measures are necessary… and means you’re failing to leverage the most important and least expensive customers you have: current customers.
Churn rate. Every business gains and loses customers; that’s a fact of business life. But still, lost customers are like failed investments. You spent money to acquire them, service them, and try to retain them… and now they’re gone.
A rising churn rate could be caused by a number of factors: Dissatisfaction with your products and services, new competition in your market, or even the coming end of a product or service cycle.
Churn rate is a solid indicator of rising CAC and lower LTV. In fact, all three are great leading indicators of problems—or successes—to come, both in other metrics and for your business overall.
Revenue percentages. Very few businesses only have one source of revenue. Most have multiple sources, and changes in the contribution percentage each makes can indicate problems are ahead.
Take wedding photography, a business I know something about. To keep things simple, say 80 percent of revenue historically comes from the initial wedding package sold to couples, 10 percent from additional sales after the wedding to the couple, and 10 percent from post-wedding sales to friends, family, etc. If post-wedding sales fall off that will impact overall profit levels since almost all marketing and sales costs go into booking weddings so margins on additional sales are naturally much higher.
Changes in revenue percentages can often signal not only changes in customer spending habits but also broader trends in your industry and market.
If you have other key metrics your business follows, share them in the comments below.
Showing posts with label Analysis. Show all posts
Showing posts with label Analysis. Show all posts
9/7/11
The Math Behind Your Company Valuation
What you need to know to increase the value of your business for a financial buyer
Have you ever wondered what a business like yours would sell for?
It's a fair question, but focusing on your valuation is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number–and to move it up or down–you have to understand the calculation.
Financial buyers (I'll save strategic buyers for another column) acquiring a company will usually do some math to figure out what they are willing to pay today for the rights to your business's future profits.
We've all made a similar calculation. For example, you may have decided in the past to invest $100 in a bond that offers 5 percent interest per year; that is, you decided to spend $100 on something that would be worth $105 a year later.
To see how this math affects the value of your business, imagine you have a company that you expect to generate $100,000 in pre-tax profit next year. Buyers looking for a 15 percent return on their money in one year would pay $86,957 ($100,000 divided by 1.15) today for $100,000 a year from now.
When valuing a business, financial buyers will typically value not only the next year's profit, but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profits, they will "discount" the future profit you are projecting by the rate of return they expect.
For example, if you project your company will generate $100,000 of profit per year for the next 10 years (sort of a silly example because no company generates exactly $100,000 a year for ten straight years and then nothing in the eleventh year but I'll use it for simplicity), financial buyers would "discount" the $100,000 by 15 percent for each year they have to wait for their money:
Therefore, an investor looking for a 15 percent return on his or her money would pay $501,878 (in MBA parlance, this is called "net present value") today for a business that he or she expects to generate $100,000 a year for the next 10 years.
The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be: the riskier the investment, the higher the return an investor will demand. Today, investors can put their money into relatively safe bonds and get a few percentage points of return, or they can buy a balanced portfolio of big-company stocks and expect perhaps a seven or eight percent return over time.
But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money. For illustrative purposes, imagine an investor is looking for a 50 percent return for buying your business because he or she deems your future stream of profits to be very risky (or the likelihood of you meeting the targets very uncertain). The following table illustrates the effect a 50 percent discount rate has on the value of a business projecting $100,000 in profits per year:
The same business projected to generate $100,000 for the next 10 years is worth less than half as much when, due to perceived risk, the investor demands a return of 50 percent instead of 15 percent.
To understand the relationship between growth potential and value, imagine that, instead of generating a flat $100,000 in profit for the next 10 years, you expect profits to grow by 20 percent each year in the future. The table below illustrates how a financial buyer, looking for a 15 percent return on his or her investment, might value this company.
Note that the only change between this example and the one using a 15 percent return on investment is the projected growth rate. The business expecting a 20 percent growth rate over the next 10 years is worth more than double the business that expects its revenue to remain flat.
In the end, as a business owner, you have three levers to manipulate in order to increase the value of your business for a financial buyer: how much profit you expect to make in the future, the rate of growth of your profit each year, and the degree of risk associated with your future profit stream.
http://www.inc.com/articles/201109/the-math-behind-your-company-valuation.html
Have you ever wondered what a business like yours would sell for?
It's a fair question, but focusing on your valuation is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number–and to move it up or down–you have to understand the calculation.
Financial buyers (I'll save strategic buyers for another column) acquiring a company will usually do some math to figure out what they are willing to pay today for the rights to your business's future profits.
We've all made a similar calculation. For example, you may have decided in the past to invest $100 in a bond that offers 5 percent interest per year; that is, you decided to spend $100 on something that would be worth $105 a year later.
To see how this math affects the value of your business, imagine you have a company that you expect to generate $100,000 in pre-tax profit next year. Buyers looking for a 15 percent return on their money in one year would pay $86,957 ($100,000 divided by 1.15) today for $100,000 a year from now.
When valuing a business, financial buyers will typically value not only the next year's profit, but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profits, they will "discount" the future profit you are projecting by the rate of return they expect.
For example, if you project your company will generate $100,000 of profit per year for the next 10 years (sort of a silly example because no company generates exactly $100,000 a year for ten straight years and then nothing in the eleventh year but I'll use it for simplicity), financial buyers would "discount" the $100,000 by 15 percent for each year they have to wait for their money:
| End of year | Pre-tax profit | 15% discount |
| 1 | $100,000 | $86,957 |
| 2 | $100,000 | $75,614 |
| 3 | $100,000 | $65,752 |
| 4 | $100,000 | $57,175 |
| 5 | $100,000 | $49,718 |
| 6 | $100,000 | $43,233 |
| 7 | $100,000 | $37,594 |
| 8 | $100,000 | $32,690 |
| 9 | $100,000 | $28,426 |
| 10 | $100,000 | $24,719 |
| Net present value | $501,878 |
Therefore, an investor looking for a 15 percent return on his or her money would pay $501,878 (in MBA parlance, this is called "net present value") today for a business that he or she expects to generate $100,000 a year for the next 10 years.
The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be: the riskier the investment, the higher the return an investor will demand. Today, investors can put their money into relatively safe bonds and get a few percentage points of return, or they can buy a balanced portfolio of big-company stocks and expect perhaps a seven or eight percent return over time.
But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money. For illustrative purposes, imagine an investor is looking for a 50 percent return for buying your business because he or she deems your future stream of profits to be very risky (or the likelihood of you meeting the targets very uncertain). The following table illustrates the effect a 50 percent discount rate has on the value of a business projecting $100,000 in profits per year:
| End of year | Pre-tax profit | 50% discount |
| 1 | $100,000 | $66,667 |
| 2 | $100,000 | $44,444 |
| 3 | $100,000 | $29,630 |
| 4 | $100,000 | $19,753 |
| 5 | $100,000 | $13,169 |
| 6 | $100,000 | $8,779 |
| 7 | $100,000 | $5,853 |
| 8 | $100,000 | $3,902 |
| 9 | $100,000 | $2,601 |
| 10 | $100,000 | $1,734 |
| Net present value | | $196,532 |
The same business projected to generate $100,000 for the next 10 years is worth less than half as much when, due to perceived risk, the investor demands a return of 50 percent instead of 15 percent.
To understand the relationship between growth potential and value, imagine that, instead of generating a flat $100,000 in profit for the next 10 years, you expect profits to grow by 20 percent each year in the future. The table below illustrates how a financial buyer, looking for a 15 percent return on his or her investment, might value this company.
| End of year | Pre-tax profit growing at 20% per year | 15% discount |
| 1 | $120,000 | $104,348 |
| 2 | $144,000 | $108,885 |
| 3 | $172,800 | $113,619 |
| 4 | $207,360 | $118,559 |
| 5 | $248,832 | $123,714 |
| 6 | $298,598 | $129,092 |
| 7 | $358,318 | $134,705 |
| 8 | $429,982 | $140,562 |
| 9 | $515,978 | $146,673 |
| 10 | $619,174 | $153,050 |
| Net present value | | $1,273,207 |
Note that the only change between this example and the one using a 15 percent return on investment is the projected growth rate. The business expecting a 20 percent growth rate over the next 10 years is worth more than double the business that expects its revenue to remain flat.
In the end, as a business owner, you have three levers to manipulate in order to increase the value of your business for a financial buyer: how much profit you expect to make in the future, the rate of growth of your profit each year, and the degree of risk associated with your future profit stream.
http://www.inc.com/articles/201109/the-math-behind-your-company-valuation.html
5/18/11
Business Plans by the Numbers
When writing a business plan, here's how to run the numbers that matter without getting hung-up on those that don't.
Entrepreneurs are a courageous bunch—except when it comes to math. I've seen many notoriously tough senior executives shudder at the prospect of running financial projections for their business plans. So I've developed a much kinder, simpler guide to help you crunch the numbers that matter most.
Break-Even Analysis
The most important numbers for a start-up are often the most basic. Among them: Predicting what it will take to have more money coming in per month than going out. Get that wrong, and you could find yourself out of cash, and out of business.
Start by estimating the revenues generated by an average sale. Then subtract the costs that change with each transaction, like sales commissions and costs of producing the products sold. The result is your "unit contribution." Next, predict your monthly overhead, or expenses that don't vary directly with sales volume, such as rent, salaries, utilities, legal fees, and accounting expenses. Finally, divide your monthly overhead by your unit contribution. That number will tell you how many transactions you'll need per month to break-even.
Now for the analysis. Is that a realistic sales target? When do you think you'll hit it? What resources will you need to get there? How much cash will you burn through in the meantime?
Marketing Efficiency
If you reach customers directly—as opposed to selling your products to a wholesaler or retailer that will then sell to customers—then make sure each of them brings in more money than it costs you to get them in the door. Get that basic number wrong, and no amount of sales volume will save you.
First, estimate the cost of acquiring one customer, by researching similar companies, and forming a hypothesis you'll test and hone over time. Then, estimate the lifetime value per customer. Predict how long an average customer will stick around, and how much unit contribution they'll generate during that time. Ideally, the lifetime value of a customer should be three or more times greater than the cost of acquiring a customer.
Financial Projections
Projecting your financials will help you develop a sense for how to expect money to flow in and out of your business over the first few years. The numbers here are very difficult to predict, so don't waste too much time on them. Instead, run the numbers in a simple way, and adjust them as you get real revenue and expense data. If you don't understand the basics of finance and accounting, or know how to use a spreadsheet program like Excel, you should probably get help. But make sure you understand how the equations work, and what they mean for your business. Here are the most important takeaways from your financial projections:
Opportunity to scale: While it's nearly impossible to predict how big your company can get, it's helpful to make an order of magnitude estimate (Are you shooting for sales of $1 million, $10 million, or $100 million?). That will help investors, partners, and other stakeholders grasp the attractiveness of your opportunity and help them know that if things go well the rewards will be worth the risks. Also, make sure your scale is reasonable. One way to do this is to look at comparable companies. How long did it take them to reach a similar size, and how much did it cost them?
Capital requirements: It's important to estimate how much money you'll need over the course of the next year in order to break-even. That way, you can get enough cash in the bank to allow you to focus on running the business for a while before needing to spend your energy lining up more financing.
You can always go deeper, but understanding these basic numbers will help you make smarter choices without getting bogged down in analysis-paralysis.
http://www.inc.com/articles/201105/business-plan-financials.html
Entrepreneurs are a courageous bunch—except when it comes to math. I've seen many notoriously tough senior executives shudder at the prospect of running financial projections for their business plans. So I've developed a much kinder, simpler guide to help you crunch the numbers that matter most.
Break-Even Analysis
The most important numbers for a start-up are often the most basic. Among them: Predicting what it will take to have more money coming in per month than going out. Get that wrong, and you could find yourself out of cash, and out of business.
Start by estimating the revenues generated by an average sale. Then subtract the costs that change with each transaction, like sales commissions and costs of producing the products sold. The result is your "unit contribution." Next, predict your monthly overhead, or expenses that don't vary directly with sales volume, such as rent, salaries, utilities, legal fees, and accounting expenses. Finally, divide your monthly overhead by your unit contribution. That number will tell you how many transactions you'll need per month to break-even.
Now for the analysis. Is that a realistic sales target? When do you think you'll hit it? What resources will you need to get there? How much cash will you burn through in the meantime?
Marketing Efficiency
If you reach customers directly—as opposed to selling your products to a wholesaler or retailer that will then sell to customers—then make sure each of them brings in more money than it costs you to get them in the door. Get that basic number wrong, and no amount of sales volume will save you.
First, estimate the cost of acquiring one customer, by researching similar companies, and forming a hypothesis you'll test and hone over time. Then, estimate the lifetime value per customer. Predict how long an average customer will stick around, and how much unit contribution they'll generate during that time. Ideally, the lifetime value of a customer should be three or more times greater than the cost of acquiring a customer.
Financial Projections
Projecting your financials will help you develop a sense for how to expect money to flow in and out of your business over the first few years. The numbers here are very difficult to predict, so don't waste too much time on them. Instead, run the numbers in a simple way, and adjust them as you get real revenue and expense data. If you don't understand the basics of finance and accounting, or know how to use a spreadsheet program like Excel, you should probably get help. But make sure you understand how the equations work, and what they mean for your business. Here are the most important takeaways from your financial projections:
Opportunity to scale: While it's nearly impossible to predict how big your company can get, it's helpful to make an order of magnitude estimate (Are you shooting for sales of $1 million, $10 million, or $100 million?). That will help investors, partners, and other stakeholders grasp the attractiveness of your opportunity and help them know that if things go well the rewards will be worth the risks. Also, make sure your scale is reasonable. One way to do this is to look at comparable companies. How long did it take them to reach a similar size, and how much did it cost them?
Capital requirements: It's important to estimate how much money you'll need over the course of the next year in order to break-even. That way, you can get enough cash in the bank to allow you to focus on running the business for a while before needing to spend your energy lining up more financing.
You can always go deeper, but understanding these basic numbers will help you make smarter choices without getting bogged down in analysis-paralysis.
http://www.inc.com/articles/201105/business-plan-financials.html
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