Today’s guest post is by Bob Low. Bob has authored two books—Accounting and Finance for Small Business Made Easy (Entrepreneur Press) and Bottom Line Basics (Oasis Press) covering the essentials of financial management for non-financial managers. He’s an interim CFO for emerging growth companies and has shared his insights on non-GAAP metrics…
Bob: Consider an analogy between a baseball manager and an entrepreneur running a company. Baseball has box scores and a number of commonly used performance measures such as batting averages, saves, and ERA. There are specific rules about how to calculate them and the consistency in how they are measured allow statistics to be compared across different teams and seasons. In business, GAAP financial statements have many of the same characteristics. Consistent rules, definitions, and financial periods allow investors to objectively assess and compare financial performance across periods and companies.
The problem for the baseball manager and entrepreneur is that this standard reporting doesn’t meet all their needs. A box score published the day after a game is too late to help win the game in progress and standard statistics may not be sufficiently detailed to meet decision making needs. That’s why teams will track things like where a player hits so they can position the defense; how hitters perform against each pitcher so they can determine matchups; and track pitch counts so they optimally manage their pitching staffs. In business, standard financial statements fill an important role but they report after the fact and with limited granularity. Managers can benefit from designing measures that provide more current and tailored information.
Businesses use a variety of metrics: those with fixed capacity like hotels and airlines will track utilization (vacancy rates or percentage of seats filled). The health of sales can be tracked by looking at book-to-bill ratios. Businesses with inventory will look at turnover and any business offering credit can benefit from tracking receivables with stats like average days outstanding or the percentage of invoices more than 30 days past due. Customer returns, employee turnover, average selling price, or simply daily cash in and out can all be indicators of a business’ health or early warning signs of potential problems.
Some key thoughts in developing metrics:
- Key indicators will vary from business to business so choose what makes sense to you and don’t necessarily mimic what another company does
- Keep it simple. This makes it both easier to gather the numbers and to understand them. One business that adopted Economic Value Add (EVA), a complicated measure that blends several factors found that no one understood it and therefore no corrective actions were taken.
- Along these lines, a dashboard or balanced scorecard with multiple measures can be useful but don’t overload it so that the indicators give off mixed or confusing signals.
- Ensure the information is timely or it loses its impact
- There is no need to be constrained by definitions or timing used for formal financial statements. For example, periods don’t need to be fiscal months; billing or cash received can be a proxy for recognized revenue.
And a couple of warnings:
- Be sure you’re tracking the right numbers. Author Jack Stack tells the story of a hotel manager who focused on expenses when his key number should have been occupancy. No matter how much he drove down expenses he simply wasn’t filling enough rooms to make money.
- Make sure what you’re tracking has a direct tie to results. In the dotcom boom, businesses used metrics like unique visitors as predictors of future revenue and valuation. Though still a useful metric, unless there’s a correlation with revenue the metric itself may have little value.
Hopefully, if you’ve choose metrics well, you will both know how your business is doing without needing to wait for formal statements and have timely information for decision making. Here are some suggestions of metrics for technology companies:
- Recurring revenue run rate. This tracks the size of the customer base, measures how much high-probability and predictable revenue will be recognized, and assuming revenue is recognized ratably will lead what is recorded in financial statements.
- Recurring revenue companies should also track attrition rates. This can be used to refine projections in recurring revenue plus changes in attrition could reflect customer satisfaction or trends in the market. Tracking by product or customer type could yield further insights. At one of my companies, 2/3 of the attrition was in non-core products which highlighted both the strength of the core solutions as well as helping model the risks of seeing customers walk away rather than migrate from non-core to core solutions.
- Sales pipeline by stage and conversion rates from each stage to closed business. It’s easy to get caught up in the size of a sales funnel alone but that won’t predict future sales without knowing what stage each deal is, what the likelihood is deals will progress to closing, and how long it takes to close them.
- Professional services utilization. For businesses that provide implementation support and other services, this measure tracks what proportion of available hours are billable to customers. I suggest looking at this both by hours and revenue as overruns on fixed fee engagements or hours worked for free can increase “billable” hours without driving additional revenue
- For an interesting view of metrics from a VC, check out this article
http://bit.ly/m2F0VH (if the link doesn’t work for you, just cut and paste into your browser)