Six Measures for Start Up Success

 30 May 2011

1. Growth Equation

If there is one formula that every start up should know, then the growth equation is it.

The growth equation recognises that there are only three ways to grow the revenue of any business:

1. Increase the number of customers
2. Increase the number of times they buy from you
3. Increase the average purchase value of each transaction.

Put another way, the revenue of any business can be calculated as follows

Revenue = Number of customers X Number of times on average each customer buys from you X Average transaction value

Start ups should have strategies to grow and improve each of the elements of the calculation.  For example, to grow the number of customers, businesses need strategies to generate new leads, improve conversion rates of leads to new customers, as well as strategies to improve retention rates of existing customers.

This simple but powerful calculation is a great planning tool that can be used to forecast the outcome of these strategies.

Some other measures you should be on top of when developing these strategies are:

• The lifetime value of a customer and
• The allowable acquisition cost of a customer.

2. Cash to Cash Cycle

Without cash a business won't survive, let alone grow.  The cash to cash cycle helps businesses understand how long on average it takes in days for cash to flow through the business.

The longer the cycle, the greater the need for additional funds.  The shorter the cycle, the more frequently it can be repeated to generate more income and profit and reduce the need for working capital.

Start up businesses often have a limited capacity to access additional funds, therefore managing cash by understanding the cycle is critically important.  Once businesses calculate their current cycle, they should put in place actions to shorten each stage.

3. Profit Margins

Profit margins are the key profitability measures that every business should know by product lines and by key customers.

Gross Profit Margin is the dollar amount (often expressed as a percentage) that you make on each sale before taking into account the fixed costs of the business.  Fixed costs include expenses such as office rental, marketing and administration staff wages.

The margin is calculated by deducting the variable costs of delivering your product or service from the sale price you charge.  Variable costs are ones that rise and fall based on how much revenue you have, such as purchasing raw goods and delivering the product to the customer. 

High margin businesses are typically easier to grow than low margin businesses, as they can be more easily scaled operationally and financially.  They don't need to find large amounts of cash to invest in producing or selling more of their existing product and they can typically spend more on customer acquisition.  Low margin businesses will generally have less cash to invest back into the business and will need to manage cash flow carefully or source external funds to finance growth.

Another important margin to be aware of in your business is Operating Profit Margin.  Operating profit margin is the gross margin minus all operating costs, including fixed costs.

4. Break Even Point

This is the point at which income and expenses are exactly equal.  The business has recovered all expenses, but not made a profit or loss.

Break even analysis is critical for any business owner, as it shows exactly when you begin to make a profit.  It is also a great planning tool that can be used when setting prices and the effect pricing will have on volume and profit.  The break even point is the lowest limit when determining profit margins.  You will know how low a price you can offer and the effects of discounting on your net profit.

You can calculate the break even for any period of time - a year, quarter, month, week, day - just make sure all three estimates relate to the same time period.

The formula used to calculate the quantity you need to sell to break even is:

Number of units = Total fixed costs / (Unit selling price - variable unit cost)

Or to calculate the break even in dollars:

Dollar value = Total fixed costs / 1 - (Total variable costs / total sales)

Businesses should also calculate their cash flow breakeven point.

5. Sustainable Growth Rate

The sustainable growth rate (SGR) simply tells you how fast you can grow, given the current financial performance of the business and its available financial resources. 

The SGR encourages business owners not only to focus on growth strategy but also the growth capacity of the business.  While growth is a key focus of most start ups, pursuing a growth strategy that would take the business beyond its SGR means additional funds are required.  Without putting those funding requirements in place at the right time, you risk growing beyond your means (also known as overtrading) and if not addressed early enough eventually being declared insolvent.

To avoid this, the sustainable growth rate can be used to plan healthy business growth in line with a suitable financial strategy, or to limit growth to an appropriate rate if additional funds are not available to the business.

6. Return on Investment

How well is your business performing compared to other investments?  Your business is an investment.  You need to view and analyse it, just like you would with shares or other investments.  Calculate what the return on the investment you have made into the business really is and how hard the assets are working for you.

When determining your investment in the business, you should to take into account the "sweat equity" you have reinvested back into business through foregone wages.

I have seen some businesses, where the return on investment is barely more than what you would get from a term deposit or by investing in blue chip stocks. 

Given the high risk typically involved in owning and operating a start up business you need to ask yourself - will it be worth it?