The Top 5 Financial Metrics You Should Know
In baseball, you look at a player's RBI.
In basketball, you want to know a player’s average points per game.
In football, you want to know how often a team converts on third down.
When we talk about sports, the numbers aren't scary. Many fans know all the stats for their favorite team. For those that play in a fantasy league, they may know the main stats for every team and all-star player.
It’s easy to understand what the numbers mean when you watch the game. Those stats aren’t considered to be math or nerdy - unlike when you think about financial stats.
When it comes to accounting, most people hit a mental roadblock. Business numbers are abstract compared to sports. All too often people tell me it's too difficult.
But it's not.
Accounting is how you track the score in business. When you're reviewing your company's performance, you need to know it's stats.
It's funny when watching football and an announcer rattles off some obscure stat. Like the last time X team had three sacks by the second quarter was 17 years ago. The amount of data they must track, and store, and analyze is so detailed it’s ridiculous.
You don't need to go into that level of detail for your business, but you should know a few important ones. Here are 5 financial metrics you should know for your business.
1. Net income
Net Income = Sales - Expenses
Net income is the final score. After the game is over, this is the one number that reflects your efforts. In business, this is also what the owner(s) can pay themselves.
Your net profit needs to be enough to support your lifestyle. If you need to live off of your business’s income, you still need to be profitable. Also, the IRS wants to see you that you're profitable roughly every 3 out of 5 years. Otherwise, they may consider your business an expensive hobby.
2. Gross Profit Margin (GPM)
GPM = (Sales - COGS) / Sales
Gross profit is the total sales minus the expenses directly tied to the sales. These expenses are the Cost of Goods Sold (COGS).
It is paramount to ensure that what you offer is profitable. If not, you need to stop and make some changes right away. To understand profitability, I like to look at the gross profit margin. A higher margin means the product or service is more profitable. This is a great stat to help you refine operations and create efficiencies.
It's a starting point, telling you where to focus.
You can break it down by service or product lines, regions, stores, and more to pinpoint your best products.
Before you go grab your income statement, a word of caution on COGS. Don’t get too caught up deciding what is COGS and what is a normal expense. You could argue that every business expense qualifies as a COGS. The difference is that a COGS directly relates to a sale.
For instance, if I work for an hour on a client's financials, that hour of labor is a COGS. The time I spent writing this blog, which may lead to sales down the road, does not tie to an individual sale.
Other non-COGS expenses are utilities, rent, admin workers, advertising, insurance, and office supplies.
3. Sales Conversion
Sales Conversion = # of Sales / # of Prospective Customers
Making a sale is like making a goal. The more shots you take, the more likely you are to put points on the board.
Your sales conversion rate is how many goals you make, divided by the number of shots on the goal. For your business, it’s the number of sales, divided by the number of prospective customers.
For example, say you average 1 sale for every 5 proposals. Your conversion rate is 20%. In a month, you write 30 proposals. At the current conversion rate, that means you’d make 6 sales.
This is a statistic that you have a lot of control over. To make more sales, you can improve your selling skills or get in front of more prospective customers. Going back to the example, the following month you write 40 proposals. You can reasonably expect to make 8 sales.
After a while, you'll come to see your business becomes a numbers game.
4. Savings Buffer
Savings Buffer = Savings Cash Balance / Avg Monthly Expenses
A deep bench is when you have many back-up players ready to step in if any key players get hurt. In business, you can build your bench by building up your cash reserves. This can keep you out of bankruptcy if you have a bad month or disaster strikes.
A good rule of thumb is to have three months of expenses saved.
Another benefit to having a savings buffer is if a good opportunity comes along, you have the cash on hand to act. You won’t miss out or have to borrow money. Just be sure to build back up your cash reserves after you dip into them.
5. Effective Tax Rate
Effective Tax Rate = Total Income Taxes Paid / Net Income
Prevent financial injuries by staying up to date with your taxes. I hate to see when business owners fall behind on their taxes. It’s stressful and avoidable. The remedy is to save some profit for taxes each month and make quarterly estimated payments.
To calculate how much you should save, pull out your last tax return. You calculate your effective tax rate by dividing the “total tax” line by your business’s net income. Each month, you should save that percentage of your net income for taxes.
Don't use this formula if you have a working spouse or other streams of revenue. If so, save for taxes at your marginal rate. That's the highest tax bracket you reached the prior year. You can find that percentage somewhere in the summary or extra pages of your tax return.
If you think about your business like a sports team, it’s easier to understand your key stats. They're useful in helping you build a stronger team and a legacy. accounting is how you keep score.
To play in the big leagues, you must know your net income, gross profit margin, sales conversion rate, savings buffer, and effective tax rate. These will help you coach your company through many successful seasons.
There are thousands of metrics you could track for your business. I recommend following the ones above, plus a few common ones for your industry. These are the "key performance indicators" (KPI’s).
If you keep your accounting up to date, it’s very easy to calculate all the numbers. You don’t even need to remember the formula - you can look it up or check back here. Don't psych yourself out. Computers and apps will do all the number crunching anyway.
Track your numbers, get competitive with yourself, and work on incremental improvements.
You’re in the arena. Run your company like you want to take it all the way to the championship.
You ready? Game on!!
