Do The Math: 4 Financial Metrics Your Business Should Track
by Kody Myers, on Nov 4, 2016
Having worked closely with many CEOs across several industries and growth stages, it’s become clear to us that each business has unique nuances it must focus on. People who make broad statements like, “These are the financial numbers EVERY business needs to know” are casting a very wide net and not considering your business’s unique needs.
With that said, I have noticed four specific calculations that are a common thread across every company I’ve worked with. I’m not saying to solely measure these four, nor am I saying these calculations are the most important to your business but, they will provide quick insight into how your business is performing.
Customer Acquisition Cost : Life Time Value (CAC:LTV)
This is probably one of the harder ratios to calculate for any business but it offers the most insight into the scalability and future success of that business. This ratio determines if the cost to acquire a new customer is justified when compared to the total profit you expect to collect from that customer. While the exact ‘healthy’ ratio is dependant on your business and industry it is generally agreed that a ratio of 1-to-3 is a healthy CAC:LTV ratio, meaning that for every $1 spent to acquire a new customer you’ll generate $3 in gross profit to your company. You can easily see that if this ratio is 1-to-1 or worse 2-to-1, there is no way you can scale the business because you’ll be losing money on each new customer.
How do you calculate Customer Acquisition Cost?
In the most literal sense CAC is total spend to acquire a new customer divided by the total number of new customers acquired in that period. Calculating total cost is unique to your business so you will need to think through all your costs and determine which are directly related to acquiring new customers. Typical expenses include sales commissions and salaries, advertising spend, marketing spend, etc. Let’s run through an example: Imagine last month you spent $10,000 on sales commissions and salaries, $5,000 on advertising via Facebook and Adwords, and $2,000 on marketing materials. You spent a total of $17,000 last month acquiring customers. Let’s also assume that you acquired 100 new customers from that spend. Therefore, your CAC is $17,000 / 100 = $170, meaning it cost you $170 to acquire each new customer last month.
How do you calculate the total Customer Lifetime Value (LTV)?
Again there is not a single simple calculation that can be applied for every company, but in the general sense LTV it is the total amount of gross profit you expect to ever receive from a single customer. There are many theories and great examples for calculating LTV for your specific type of business and industry. But for the sake of simplicity I will focus on the methodology rather than specific calculations.
If you are an established business and have lots of good historical data you can simply take an average of actual gross profit for each client to figure a pretty solid lifetime value. However, if you are a younger company or don’t have good data to review, it is more likely you will have to make a few assumptions to determine total lifetime value. The general calculation is total gross profit received from a client in a period multiplied by the total number of periods you expect to receive money from that client. For example, let's say your customers pay you $100 / month for your service, of that $100 top line revenue, $65 is cost of goods sold thus giving you a gross margin of $35 (100-65=35). Now you need to apply an assumed length of time they will remain a customer (let's assume 16 months), therefore your total lifetime value is $35 x 16 = $560. I recommend reading an article by Jeff Bussgang titled Your LTV Math is Wrong for a more indepth review to accurately calculate LTV.
While this calculation is simple and intuitive, it should be closely paid attention to as your business grows. Owners and investors should look at your gross margin over time to see if it is increasing, meaning you have gained some efficiencies as you’ve grown your business. Gross Margin is calculated Like this:
Gross Margin is the percentage of total revenue earned that is left over after paying the direct cost incurred to generate the incremental revenue (less cost of goods sold). There are two ways to increase your gross margin. The first is by simply increasing the amount you charge your customer - you want to make sure you’re charging the optimal amount for your product or service. The second is to lower your cost of goods sold. This can be done by negotiating better rates with vendors for raw materials or decreasing cost as you increase volume, to name a few.
This may be the number that business owners pay the most attention to as it is the measure of your business’s profitability. Similar to your personal paycheck, this is the final number that you see after all expenses and taxes have been subtracted from your income. These deductions include things that would be considered the cost of business. These costs can include, but are not limited to depreciation, interest, taxes, and business expenses. This is also often informally called your business's bottom line, because it quite literally appears as the bottom line on your P&L. The formula looks like this:
Or it is more commonly shown in an profit and loss statement like this: