Take revenue, for example. It is the mighty measuring tool of entrepreneurs. "How big is your company?" is an often-heard greeting/challenge in entrepreneurial circles. The entrepreneur in me wants to share and see how others stack up. The CPA in me laughs -- and rightfully so.
Revenue is a HORRIBLE metric to use to judge your financial health. Unfortunately, it's probably the most common tool and one of the few that business owners share freely. But it tells you so little about a company. If you sell low margin product, you need huge revenue numbers just to make a reasonable profit. On the flip side, high margin products need relatively low revenue numbers to make a fair profit. (Some states are now taxing revenue - not profit - in an effort to bring in more money -- a great reason to keep revenue low.) Remember that you can have solid revenue numbers and still lose a ton of money - it's hard to keep that kind of company in business for long.
The real problem begins when entrepreneurs try to increase revenue at all costs. It's true that in general, bringing in more money is a good thing. But some entrepreneurs take it too far and work just to increase revenue. This is usually because they think it will help with lenders, partners or the competition. But no matter the reason, growing revenue for revenue's sake is a dangerous plan. Keep the focus on growing your business the smart way - creating a unique value for your customers and controlling costs - and increased profits will follow.
There are more effective ways than revenue to measure your company -- my favorite is net income. That's a real number with tangible benefits. Look a bit deeper by using the Acid Test Ratio ((Cash + AR) / Current Liabilities) to see your current cash position. I love the Acid Test because it shows you what happens if you hit some speed bumps in your business. How long can you hold out? If your ATR is above 1, you're probably in good shape.
Check your receivables for average days outstanding on invoices to make sure you are getting paid on time. Track your profit per item or service sold to make sure you are selling the most lucrative pieces. And track this information over the long-term so that you're able to monitor trends and parse out fluctuations in seasonality or one-off disparities.
It may be tempting to measure yourself with others based on revenue, but know that you're just looking at one tiny piece of the pie. It's like judging the quality of a movie based on how much money it cost to produce -- we all know the flaws of that kind of logic. Regularly tracking more useful measurements of the health of your company as outlined here will help you keep your eye on the prize: profitability and areas for growth.
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