How to identify financial fundamentals you should know
In Thinking, Fast and Slow, the economist Daniel Kahneman explained we form thoughts in two ways. He called this System One thinking and System Two thinking.
System One is fast thinking. It is “automatic, frequent, emotional, and unconscious”. Most business owners will be familiar with this sort of quick thinking. System Two thinking is deliberate and conscious.
It’s when we seek new or missing information – and it’s when we make our most crucial decisions. When making these decisions we need information and data. That’s where financial metrics and fundamentals come in.
In this guide, we’ll look at what financial fundamentals you should know to make critical business decisions effectively.
Why are financial fundamentals important?
Financial fundamentals explain the narrative of your business.
Of course, there’s always room for intuition when running a business. But at a deeper level, metrics and key performance indicators (KPIs) sharpen and support your gut instinct (and vice versa).
So think of financial metrics as not only a search for red flags and warning signs. It is that to an extent – but the right financial metrics also help you identify new opportunities.
Seven financial metrics owners should know
There are countless metrics and KPIs that you could track. In truth, which ones are and aren’t relevant to you depends on your business.
There are a few go-to metrics you should know. The following seven metrics sketch out the core realities of running a business.
It’s also important to note that no single metric should drive your business. As the investor Jonathan Golden noted, you miss a lot by focusing on “a single headline number”.
Instead, track a few different metrics. This will give you a much clearer picture of your company’s financial health.
Revenue and real revenue
Revenue can be a vanity metric. After all, it’s a rough number that doesn’t take costs into account. It exists in a vacuum. High revenue is good – but it counts for little if it dwarves your outgoings.
So make sure to contextualise your revenue. It is the driver of your profitability. That said, if you’re a manufacturer or a retailer, then real revenue is more appropriate.
Real revenue is your revenue minus your expenditures on materials. And if you use sub-contractors, then add those costs too. In these sectors, real revenue (and not top-line revenue) is the key profit driver.
“We try to equate revenue with happy clients on the basis that the happier the clients, the longer they will stay with us and the more people they will recommend to us. So we talk about revenue, especially at team meetings, as a marker of success.”
Paul Bulpitt, co-founder of The Wow Company
Gross margin is your total sales minus the cost of goods sold (COGS). COGS is the money retained minus the costs of providing your goods and services.
In particular, it’s a good idea to think about the potential gross margin of new products or services. Through conversations with your customers, you can estimate a likely sale price.
With this figure in mind, find out how much it will cost you to produce a product or provide a service. If a new product has an insufficient gross margin, it may be better to go back to the drawing board.
Profit is the percentage of revenue that's left after deducting your expenses. The higher the percentage is, the more profitable your business is.
Profit is, naturally, a great metric to keep close tabs on. But there’s another level deeper, especially in times of higher inflation: real profit.
Real profit is your gross profit margin minus the inflation rate. For example, if your profit margin is seven per cent and the inflation rate is four per cent, the real profit is three per cent. By taking inflation into account, you understand your business’s true profitability.
Operating cash flow
Operating cash flow is the cash generated by your normal business operations. Cash flow is distinct from revenue because it captures money that you actually have to hand.
So if you make a big sale, for example, that boosts revenue. But it doesn’t count towards operational cash flow if you’re struggling to collect the money in question. It’s a day-to-day measure of your ability to keep the lights on.
Invoice payments are a real killer of cash flow. Especially when working with larger firms. Big businesses will often ask for long payment terms.
This long payment runway can put a big strain on working capital. Cash flow looks past big sales and big numbers and takes a clear look at your financial health. If late invoices are your downfall, then consider external support (like invoice financing).
Accounts receivable/Accounts payable
Accounts receivable (AR) is the money owed to you for services delivered or used but not yet paid for. Accounts payable (AP) is the reverse of that: it’s money you owe.
A classic tactic when times are tight is to delay accounts payable. But the priority should be to manage your accounts receivable better, while keeping an eye on your accounts payable.
By delaying your payments, you can sour business relationships and ruin your credit. Instead, focus on narrowing the time it takes to get money and payments in. There are ways to encourage prompt payment, like early payment discounts or deposits.
But no matter what, it’s vital to invoice immediately after providing your services.
All the services you provide should make money. And your break-even point is a good way to measure this. For this metric, you need the fixed costs and the variable costs of providing your services.
You then compare the total cost with your revenue from that product or service. Where your revenue and costs intersect is your break-even point. Anything beyond your break-even is profit.
If you’re not breaking even, then what you’re doing may hurt your finances. Either adjust or it might be time to stop.
Average customer acquisition cost and lifetime value
With online marketing and search rankings, customer acquisition cost (CAC) affects many businesses.
It’s a metric that forces you to consider your entire customer journey. The transaction is the end goal – but how did they get there? If the cost of getting a customer is more than your gross margin, you may be losing money.
You can calculate your average CAC with this simple equation. It is the cost of sales and marketing divided by the number of new customers acquired.
As always, there are exceptions to the rule. If a customer’s lifetime value (LTV) is high, then you might be happy to pay over the odds to get them. LTV is the predicted revenue that one customer will generate with you.
To calculate your LTV, calculate your average customer value. This figure is your average value multiplied by average frequency. You should use this metric alongside your average customer lifespan.
The role of the accountant
Your accountant should play a key role in helping you track and understand your key KPIs. With cloud accounting software, your adviser can access real-time financial data.
Not all accountants offer this kind of support. Many still offer quite simple services, with annual meetings to discuss business performance.
But more complex businesses need more proactive insight. Some accountants will provide a consultancy service with regular meetings to review accounts. These meetings could be weekly, fortnightly or monthly.
Having someone to speak to frequently will help you understand how to actually grow the business. Plus, you’ll get more familiar with what metrics you should be looking at.
“My current accountant is a combination of an accountant and a consultant. We have regular management meetings and go through the accounts regularly. They’ve created reports for me that I can understand and steps that we can put in place that will actually grow the business. Plus, I now know what metrics that I should be studying and keeping track of.”
Jo Lochhead, founder of The Crafty Kit Company
When to hire a financial director
At a certain point, you may need to hire an accountant full time. Hiring a financial director (FD) is quite an investment. Full-time FD salaries have a midpoint of £102,500 per annum.
However, you can always hire a FD to work part time. Or, you can use a virtual FD (who works part-time and remote).
There is a point where a more full-time FD is appropriate. Particularly any business with a debt burden or that has received investment. At that stage, an in-house financial specialist can offer real value to you.