Entrepreneur

Critical KPIs Every Entrepreneur Needs to Track

By Justin Biel for Brainyard
September 28, 2020
Financial Analysis

In short:

  • While 80% of new businesses survive the first 12 months, only half make it to the five-year mark.
  • To increase their odds of success, entrepreneurs need a strong understanding of these 12 key performance indicators.
  • Cash flow may be king, but liquidity, churn, COGs and these other KPIs are nearly as critical.

In 2019, U.S. entrepreneurs ran nearly 31 million small businesses and employed about half the country’s workers. But the pandemic hit hard: Employment among companies with 20 to 49 employees declined 21.5% between March and April, according to the U.S. Bureau of Labor Statistics, compared with 13.3% for firms with 1,000 or more workers.

Clearly, entrepreneurship in 2020 is not for the faint of heart.

You need a can-do attitude and a variety of skills to turn a great idea into a profitable business at the best of times. Now, sustaining and growing operations demands a rigorous attention to performance. That entails calculating and analyzing various KPIs, then making changes or decisions based on hard data.

Those large businesses you’re competing against tend to consider a core set of KPIs, as well as some new markers that have risen in importance this year along with indicators particular to their industries. We’d argue that smaller, still-growing businesses have their own bundle of KPIs that can keep them on the path to longevity.

Let’s start with the “king KPI.”

Cash Flow

Cash flow is the difference between the money that comes in and what flows out. Generating positive cash flow is the entrepreneur’s aim because that positive income means your business is financially viable.

In fact, business publications like StartupNation, educational institutions like the University of Omaha and financial institutions like Barclays all argue that cash flow is even more important than profit.

Positive cash flow is what helps an entrepreneur sustain and grow business operations. For instance, companies need cash to cover the cost of producing their goods or services, pay employee salaries, meet debt obligations, market and sell their products, buy equipment and rent space. Having enough cash on hand to pay the bills, fund expansion and accumulate a reserve to weather uncertainty is imperative. Thus, cash flow arguably trumps profit.

Entrepreneurs generally issue cash flow statements on a monthly basis. Cash flowing into the company, or positive cash flow, includes income received in the period. Cash flowing out, or negative cash flow, includes rent, bills and any other expenses.

Net cash flow = cash flow in cash flow out

Here’s a more detailed description of how to do cash flow analysis.

There are several different methods to calculate cash flow beyond net in/out. For example, free cash flow to equity measures the amount of cash available after reinvesting in the business, which could include distributions to shareholders or owners. Free cash flow to the firm is a measure that assumes a business has no debt and is used in financial modeling and business valuation.

Each cash flow method measures certain aspects of an organization’s financial health. Entrepreneurs should understand different cash flow analyses models and apply them depending on current business realities.

Why cash flow is king: As opposed to revenue or profit, cash flow determines if a company has the money to meet its financial obligations.

Tracking cash flow is not always straightforward. For instance, the amount of revenue a company receives may not equal the actual cash paid in any given period. That’s because a company may sell products or services on credit, and funds only become available later. Companies might also borrow, or make purchases on credit. Thus it’s essential to manage the gap between accounts receivable and accounts payable.

Lenders also analyze cash flow to determine how much financing they can provide to a business, with better cash flow encouraging more funding at lower rates.

Liquidity

Closely linked to cash flow, liquidity measures the ease with which a business can turn assets into cash. In accounting, liquidity is a company’s ability to meet financial obligations and pay off debts with liquid assets. Unfortunately, JPMorgan Chase research shows that nearly half of small businesses in urban communities have two weeks or less cash liquidity. That lack of reserves became a big problem for many when the pandemic caused lock-downs.

Cash on hand is the most liquid of all assets because it is always accepted to pay a debt. Other resources, like equipment, real estate, stock or inventory, must first be sold.

Liquidity is typically measured using the current ratio, or working capital ratio, and the quick ratio. The working capital ratio helps determine if there’s enough assets to cover short-term expenses like payroll, bills and overhead. The quick ratio is a more conservative measure because it excludes inventory, assuming that inventory may not be readily convertible into cash.

Current ratio or working capital ratio = current assets / current liabilities
* A current ratio below 1 implies negative financial performance.
Quick ratio = (assets inventory) / liabilities

There are additional liquidity ratios, such as the cash conversion cycle and cash ratio. The cash conversion cycle measures the time it takes for a company to sell inventory, receive payment and pay its creditors. Cash ratio is a more stringent measure that excludes receivables and looks only at cash and marketable securities, such as common stock, bonds and treasury bills.

Why liquidity is important: Liquid cash is essential to small businesses for a few reasons. Of course, it enables them to meet debt requirements, such as monthly payments on loans. Liquidity also provides security in the face of unexpected problems, such that a company could avoid laying off valued employees.

Like cash flow, liquidity is a measure of financial stability.

Customer Acquisition Cost

Customer acquisition cost (CAC) is the amount of money your company spends to acquire and retain its customers. CAC directly impacts profitability, making it a crucial metric for growing firms.

Even with the right product and market fit, if you can’t acquire customers at a low enough cost to be profitable, that can be a “startup killer,” according to serial entrepreneur and VC David Skok.

To calculate CAC, look at what you spend to generate leads and turn them into paying customers. Customer acquisition costs include marketing and advertising, sales and marketing employee salaries and benefits and other related overhead. CAC should be calculated over a particular time, say a month, quarter or year, depending on your business.

CAC = (total cost of sales + marketing) / number of new customer acquired

Keep in mind that the formula above is a basic example. You’ll need to factor in the nuances of your “total cost of sales and marketing,” such as how long it takes for someone to become a customer. Andreessen Horowitz partner Andrew Chen has more to say on the nuances of CAC formulas and how they apply.

The importance of CAC: Reducing CAC by, for example, acquiring customers at a lower cost, results in a more profitable company. Achieving a low CAC shows that your sales and marketing activities are impactful, imperative for entrepreneurs with tight operating budgets.

Of course, once you’ve acquired customers, you need to keep them and drive additional sales over time. Essentially, if the cost to acquire customers exceeds the revenue they deliver over their purchasing lifetimes, then your business model is flawed.

Note that you should spend on keeping existing customers happy because they cost less to retain, are more likely to purchase additional products and tend to spend more per purchase than their newly acquired counterparts.

Using CAC to enhance your business

When starting a new business, run through some estimates to determine the cost of acquiring new customers. Additionally, consider the lifetime value (see KPI No. 4 below) of that customer, and make sure it exceeds acquisition costs.

Depending on the kind of business you operate, there are ways to lower your CAC.

Forbes contributor Steve Olenski recommends driving higher conversions with A/B testing across webpages as a way to determine which marketing messages work best. There are also lots of free, web-based marketing techniques, such as inbound marketing (including social media) and the touchless conversion and product-led business models.

Lifetime Value

A customer’s lifetime value (LTV) is the total money a customer spends with a business. Calculating LTV helps companies understand essential information, such as how much they should spend to acquire customers, the financial impact of losing customers and the total revenue a new customer could be expected to produce.

Companies with increasing LTV show that they’ve built good relationships with clients because those people spend more money over time. Decreasing LTV indicates that customers aren’t as happy as they once were. Causes could be increased competition or decreased demand or customer satisfaction.

As a KPI, LTV charts value over the customer’s lifespan, which varies depending on the industry and organization. When customer data is sparse at the start of a venture, LTV is an estimate; the metric becomes more reliable over time.

To calculate LTV, multiply customer lifespan by customer spend in a given interval, like annually or monthly.

Customer lifetime value = (average customer spend per interval x customer lifespan) (cost of products or service + CAC)

Many LTV calculations depend on averages, such as purchase value, purchase frequency rate and customer lifespan. Still, LTV is an important measurement because it helps identify valuable customer groups.

Consider LTV calculations that cover both historical and predictive analysis. Each method can be useful when assessing LTV from different perspectives, such as past buyers, purchases segmented by customer type or future purchase behaviors. Google Analytics also has a free service that allows users to access LTV data with the ability to specify date ranges and view data on revenue, transactions and more.

LTV is a measure of profit, not revenue: The critical thing to understand about LTV is that it accounts for profit, not revenue. Leadership Institute for Entrepreneurs CEO Mike McCausland highlights several ways to increase LTV, including building recurring revenue sources like subscriptions, expanding your product line, developing scalable pricing models, reducing production costs or COGS, increasing retention and minimizing capital cost.

Revenue Growth Rates

Revenue growth rates measure the month-to-month percentage increase in revenue, which indicates how quickly your company is growing.

Revenue growth rates allow founders to see how business is progressing and can be a crucial metric for investors. Growth-stage businesses should measure revenue growth monthly to confirm that they’re heading in the right direction. However, as your organization matures, consider measuring revenue growth rates quarter to quarter or year to year.

To calculate revenue growth rate, subtract the current period’s revenue from the previous period’s over a set period of time, typically a month, quarter or year. Next, divide that number by the first period’s revenue, then multiply by 100 to get a percentage.

Revenue growth rate % = 100 x (first period revenue second period revenue) / first period revenue

If a company recognizes all revenue at the time of sale, revenue growth is a fairly straightforward calculation. However, if revenue recognition takes place over time, such as in a service subscription business, that can impact calculations. Therefore, it’s important for these companies to pull calculations over several periods to get an accurate view of revenue growth.

Growth rates can measure other business metrics that are more or less useful depending on the type of company you operate. ProfitWell explains how to calculate growth rate for two other measures, market share and user base, and the benefits of each.

What’s a reasonable revenue growth rate? It’s challenging to identify a good or suboptimal revenue growth rate because the measurement depends on several factors. For instance, smaller companies may see higher revenue growth rates than more established companies when they are in a phase of rapid expansion, and comparatively small sales increases will impact revenue growth more. Comparing your revenue growth rates with those of companies in the same industry at similar growth stages is the best way to see how you match up against the competition.

Revenue growth rates can also be measured against overall industry norms or your company’s internal sales benchmarks.

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Additionally, industry revenue growth rates vary in sub-categories. For example, in Q2 2020 — obviously an anomalous period — the technology sector had year-over-year revenue growth rate of 4.1%, according to CSIMarket. However, certain categories within the sector, such as consumer electronics, saw a decreasing revenue growth rate, at -1.83%, while other categories, such as communications equipment, outperformed the industry average with a revenue growth rate of 26.46%.

Different industries also use different terminology when talking about this metric. For instance, in retail, it’s common to look at same store year-over-year or quarter-over-quarter sales as a way to see which stores and markets are performing well.

Revenue growth rates vary, but in a good economy, companies fall between 15% and 45% for year-over-year revenue growth on average, reports Geckoboard.

Gross Margin

Gross margin is the sales revenue, or percentage of sales revenue, a company takes home after subtracting the costs associated with producing a product or service (COGS).

Gross margin is an even more critical KPI than total net sales because it shows how much of each dollar you keep, on a product-by-product basis. For instance, you might have very high sales revenue for a particular product, but if the item costs a lot to produce and/or market, then the gross or unit margin is low. Gross margin determines how much you actually take home from each unit.

Companies calculate gross margin by dividing gross profit by total revenue over any period. To find gross profit, subtract the cost of goods sold, or COGS, from total revenue.

Gross margin = (gross profit / total revenue) x 100

Product companies need to accurately account for COGS to produce an accurate gross margin. An expense is included as COGS if it would no longer exist if the revenue-producing product or service was discontinued, says business adviser Steve Davies.

It’s also important to note that COGS varies depending on the type of business you operate. Services companies will typically have a lower COGS but higher overhead. Davies offers gross margin calculations for product-based companies, manufacturers and service companies.

What gross margin says about your business: Gross margin determines a company’s ability to reinvest, pay debts, cover overhead and grow.

Keep in mind that gross margin and net margin are not the same. Gross margin doesn’t reflect other costs of running a business, like administrative and interest expenses. Therefore, net margin will always be less than gross margin.

You can view gross margin across a product line to see how categories are performing overall. You can also evaluate it at the per-product level, which gives insight into how individual items are doing and assists with inventory decisions. For instance, a high gross margin on a product might be a reason to promote the product more aggressively. But if a product has a low gross margin, it could make sense to try and lower COGS, find more effective marketing channels or discontinue the product.

What’s considered a “typical” gross margin varies by industry and type of business. In general, high-priced luxury goods, some services and many business technology products tend to have higher gross margins than mass-market consumer products. Research your industry, find general guidelines around gross margins and then work to beat the industry average. Brainyard’s KPI pages, like this one for apparel, can help set a benchmark.

Customer Churn

Customer churn measures the number of customers that stopped using your service over time, as a percentage. Customer churn has a substantial impact: CallMiner estimates that U.S. businesses lose $136 billion a year because of churn.

Churn = # of customers lost in a period / (customers at start of period + customers gained in period)

All companies have some churn, with some industries experiencing more than others. A commodity services business, like a hair salon, will measure churn differently from a luxury auto dealership. As we’ve discussed in the context of KPIs for consultancies, you also may not value all customers equally in your calculation. A customer who leaves in the first 90 days of a subscription, or after the first engagement, shouldn’t carry the same weight as losing a customer who’s been with your firm for a few years.

Still, minimizing churn, aka increasing customer retention, is important to your bottom line. According to SmallBizTrends, 65% of a company’s business comes from existing customers.

Analyzing and reducing customer churn: High customer churn means products or services are not meeting customer expectations, for whatever reason. Barring major external forces, you likely have problems at the product, service or customer-support level.

Note that if you’re seeing churn rise, one area to look at right away is how you invoice. Inaccurate, sporadic, confusing or incomplete invoices can damage customer perceptions of your company.

Note that there are different categories of customer churn. For example, contractual churn is when a customer fails to renew a subscription. Voluntary churn is when a customer cancels an existing service. Non-contractual churn is when a customer fails to finalize an online or in-store purchase.

If churn is too high or suddenly growing, take action. Dig into data to determine which customer segments are leaving or likely to leave and work to discover why. Talk with customers about the product experience and service interactions to determine what’s driving them away. Identify at-risk customer groups, and work to keep them onboard.

Burn Rate

Burn rate measures how quickly a company is spending money to operate the business. Tracking burn rate is vital for entrepreneurs because it allows them to know if they have enough money to continue operating and building the business. Burn rate also shows how much time, or runway, the company has before it runs out of money, requires additional investment or needs to start generating profit.

Burn rate is usually calculated as gross burn rate or net burn rate. Gross burn rate measures a company’s total operating expenses. Net burn rate measures a company’s operating losses.

Gross burn rate = sum of all operating costs in a given period, usually in a month
Net burn rate = gross burn rate sales

How much runway does a startup need?

Seed-stage (aka pre-revenue) startups should aim for 18 months of runway, according to a study by a startup initiative at Florida International University, so they have the leeway to develop and prove the viability of their product ideas. The FIU study tracked time lapses between various funding rounds and is worth a look for those depending on VC cash.

Understanding and tracking runway is imperative, especially since the second most common reason startups fail is a lack of cash. Additionally, investors rely on burn rates to analyze the efficiency of business operations, determine immediate cash needs and predict future capital requirements.

Managing burn rate is an essential component of company operations for entrepreneurs looking to operate lean while figuring out how to grow sustainably.

Sell-Through Rate

Sell-through rate is an inventory turnover KPI that measures the amount of goods sold versus the amount of inventory received in a given period. From an accounting perspective, sell-through rate determines the speed at which a company turns stock into revenue, making it one of the most important KPIs for inventory management.

Sell-through rate, commonly represented as a percentage, allows a company to compare sales of different products or measure a single product’s performance over different periods. Companies typically calculate sell-through rates monthly, but sell-through can be measured over any period.

Analyzing sell-through rates also allows companies to find the right balance of inventory. That’s a huge challenge, particularly leading into the holidays when organizations need to have enough stock on hand to satisfy customer demand, but having too much product leads to the need to sell items at discounts to calculate your sell-through rate, use the formula below.

Sell-through rate = (# of units sold during period / # of units received at start of period) x 100

Want to find your company’s sell-through? Check out this sell-through rate calculator.

Analyzing sell-through rate: The Corporate Finance Institute identifies a good sell-through rate as 70% or higher, though that largely depends on the product.

So how does your company match up? Do you have a low sell-through rate? If so, maybe you need to push more sales each month with better online marketing, increased sales call capacity or an adjusted pricing structure. If sales are consistent and extra stock remains each month, maybe it’s time to order less.

The goal is to evaluate sell-through rate and make adjustments to reach more efficient inventory levels. When analyzing low sell-through, it’s vital to uncover the underlying causes and develop strategies to achieve better results.

Conversion Rate

Conversion rate tracks the number of times a customer takes the desired action from a company’s webpage, landing page or advertisement. Conversion rate can measure different KPIs, such as online purchases, clicks on digital ads, email marketing sign-ups, downloads or service upgrades.

Conversions are actions that bring potential customers closer to the brand or product in the hopes of converting them into paying customers. Analyzing conversion rates helps companies see if they’re meeting business goals by filling marketing and sales funnels.

To identify the conversion rate for any customer action, use the formula below.

Conversion rate = 100 * number of customers that took a desired action / number of total customers offered the action

Analyzing conversion rates: To get an accurate conversion rate, you need a relatively large data sample. Large companies with lots of website traffic can pull reliable conversion rate data, but newer companies need to build a substantial base.

To effectively analyze conversion rates, you need to go a step further than just seeing how many people take action and evaluating the final return on investment for that action. For example, if you get lots of clicks on a digital advertisement — meeting your team’s definition of “a conversion” — but none of the clicks convert to sales, you’re not spending marketing dollars effectively, and you need to analyze what’s preventing that final conversion step.

Look for marketing and advertising activities with high conversion rates that generate revenue amounts that outweigh the cost of acquiring those conversions.

CXL recommends increasing conversion rates using tactics such as A/B testing, offering a clear value proposition, building a sales funnel, addressing customer objections, communicating value, building trust with customers, providing proof for product claims and removing purchasing risks with guarantees.

In 2020, the customer journey has changed. Your marketing team needs to adapt. Although you may not be able to tackle all these initiatives at once, take time to evaluable your website, marketing and sales activities and remove anything that blocks conversions.

Cost of Goods Sold

Cost of goods sold (COGS) is the expenses a business incurs to produce its products. Companies calculate COGS differently depending on the type of business — normal expenses are direct costs, such as raw materials and labor, and may include the manufacturing equipment needed for production. Distribution, selling or overhead costs are not usually included in COGS.

COGS subtracted from gross sales on a company’s income statement derives gross margin. Because gross margin has a considerable impact on a company’s ability to support growth, COGS significantly affects business operations.

To find COGS for any period, add up all the costs required to procure or produce a product.

COGS = Starting inventory + purchases ending inventory

COGS differs by product and industry: All businesses have some expenses for COGS, but the associated costs are different. For instance, a consumer-product company will calculate the raw materials, manufacturing costs and packaging needed to produce a product. A software or technology company includes the costs to deliver the application, such as hosting fees, web fees, support personnel fees and onboarding costs.

Find the COGS expenses for your product, compare that to the industry average, and explore creative ways to reduce costs while keeping product quality high. Here are some real-world examples.

Monthly Recurring Revenue

Monthly recurring revenue (MRR) is a KPI used by, for example, services and software businesses to calculate revenue from billing customers each month. Developing a business around recurring revenue is an attractive model because each customer conversion results in recurring revenue versus a one-time payment. Even product companies are looking to add MRR by selling, for example, service contracts.

To calculate MRR, calculate the fee paid by every subscriber in a given month.

MRR (customer-to-customer) = sum of all customer’s subscriptions fees in a given month

MRR’s impact on business models: All subscription businesses have churn, but a strong customer base built on MRR offers benefits, such as revenue predictability and more accurate forecasting, and makes budgeting and forecasting easier. The downside is that the return on an investment in a new service comes over months and years, often requiring that the creation of a new service be financed in some way.

Entrepreneurs use MRR to determine if a business is growing or shrinking and to analyze revenue across different periods, such as months or years.

For MRR-based businesses, such as SaaS companies, monthly box subscriptions and streaming services, the key KPIs related to MRR are customer acquisition cost (CAC) and lifetime value (LTV). Once you understand the cost of getting a customer and know how much revenue she will bring to your business over time (LTV), you’re in a great place to design a scalable business model.

Bottom Line

Entrepreneurs have lots of hurdles to overcome on the way to building sustainable, long-term businesses. However, by understanding critical KPIs, you’ll be better positioned to assess business models properly, understand the relationship between key metrics and make adjustments that benefit your company.

Justin Biel is a contributing editor at Brainyard. He covers a wide range of business topics with an emphasis on entrepreneurship, marketing, branding and fundraising. Justin worked as a freelance journalist and copywriter and spent a decade as an entrepreneur.

Mark Bianco

For more helpful information from the Brainyard and our friends at Grow Wire and the NetSuite Blog, visit the Business Now Resource Guide.

  

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