Today, we’re going to talk about the three most important numbers in business.

The numbers that if you knew nothing else, you could know enough.

We’re going to dig into the three most important questions:

1. Am I making money?
2. Do I have enough cash?
3. Is my business growing?

And show you how to measure these three things.

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The only 3 numbers you’ll ever need

When I talk to business owners and leaders, I hear over and over again how complicated Accounting and Financial Statements are.

As someone who has done this work my whole career, I actually agree. We make accounting way too complicated.

Yes, all the rules and “in the weeds” details truly are complicated. But most people don’t need to know all those things.

The reality is, most people only want the answer to a few questions:

1. Am I making money?
2. Do I have enough cash?
3. Is my business growing?

When I came to this conclusion, I realized something: you only need to know 3 things to know how your business is doing:

1. Profit
2. Cash flow
3. Value Creation

Let's dive in.

Profit

Profit is at the same time understood and misunderstood in the business finance world.

Often, when you talk profit, people assume you’re talking about cash in the door.

Other times, they assume EBITDA or Operating Profit over true Net Profit.

So, what is profit?

Net Profit is the value generated from your business after sales and expenses are accounted for. Other terms you’ll here are “Net Income” and “Earnings.”

For a business to be successful, you have to generate profit. Sure there are fringe cases where that’s not true, but we aren’t here to talk about fringe cases.

To get to profit, you need to understand the Income Statement.

The Income Statement formula is: Revenue - Expenses = Profit

If you want more specifics about what Revenue or Expenses are, ​go to my resource here​ and read about it.

When evaluating profit, there are a few things to consider:

1. What is driving profit and how can we generate more?
2. What should our expected profit percentage (margin) be?
3. Are we generating enough profit to support the business and its owners?

Let’s break these down.

What is driving profit and how can we generate more?

In each business, you’ll typically have a handful of drivers that have an outsized impact on profits. If you just look for the biggest numbers, you’ll find them there.

These are often:

1. Revenue
2. Cost of Goods Sold
3. Software & Subscriptions
4. Payroll

Slight changes in the big drivers you have can drastically change your profits.

For example, if you sell $100 in services (recorded as revenue) and have $70 in monthly subscriptions, you make $30 in profit (assuming no other expenses). But if that $100 in services was only 2 sales and you lose one the next month, that $30 in profit turns into a $20 loss.

By understanding what’s driving profit (and thus understanding your revenue), you bring your focus to these items to ensure profit doesn’t turn south.

Once you understand the drivers, you have to be able to dissect them.

With revenue, you want to understand:

1. what buttons to push to grow it
2. when to hit the “eject” button on a stream

Either of these things can generate more profit.

Know the right buttons at the right time is half the battle in business.

Understanding your different revenue streams and sub-drivers beneath the main drivers helps you understand how to quickly adapt your business to changing markets.

By understanding your key drivers, you can establish KPIs to measure these drivers. Common profit related KPIs are:

• Revenue Growth
• Gross Margin
• Gross Margin Trend
• Overhead Burden
• Profit Margin
• Profit Margin Trend
• Units sold

What should our expected profit percentage (margin) be?

Every company should have a profit margin goal. Your goal will be affected by a few things:

1. Industry averages
2. Company stage/size
3. Owner’s preferences

By having a goal, you’re able to look quickly at your financials and see if you met your goal and where you’re trending. It’s one of the easiest metrics to monitor and can be extremely telling of a company’s health.

Some may look at EBITDA or other similar metrics, but as long as you’re consistent it doesn’t matter.

While I can’t give you a number, I can pose this question: what profit margin would be more attractive than your other alternatives?

Money deployed in your business is an investment and there are plenty of vehicles to get a return on investment. Real estate, the stock market, just to name a few. No business should run as a charity, so your profit margin goal should be set so that you maximize your return, even compared to other asset classes.

Are we generating enough profit to support the business and its owners?

Each business operates by the rules the business owner sets. As a business owner, you need to have a concrete vision for what you’re trying to achieve.

If it’s growth at all costs, profit might not be a focus (and you’ll focus on revenue instead).

If it’s your standard of living, profit might be the most important metric of all (along with cash flow).

This is extremely personal and an area I can’t give you a prescriptive answer. But, think of this in terms of building the owner’s wealth and cash flow.

Ask: what wealth and/or cash flow goals does the owner have and how is this profit helping them achieve them?

But these don’t capture the full picture. We’ve only talked Income Statement. Let’s talk about cash flow next.

Cash Flow

When I talk to business owners, I always like to ask: how often do you look at your bank statement?

Too often, this answer is daily. Now, don’t get me wrong… cash balances are important. But unfortunately, many business owners manage based off that cash balance.

There are a few problems with this: it’s a lagging measure. That means that when you see cash move, it’s moving because of actions taken weeks, months, or even years in the past.

Let’s talk about what this means. Too often, those in the business can feel a slow down coming.

Your call volume decreases. Requests from clients get more sparse. You start to feel just busy instead of crazy busy.

But, you look at your financials and your cash balance and all seems fine. It gives you a level of comfort that is not merited.

Then, 2 months later, you’re plugging along with the new normal and your cash balance starts to decrease. First, you tell yourself it’s just one week or one month. Next month will be better. Then next month is worse. At this point, your panic sets in.

Should I stop paying suppliers? Am I going to make payroll? Is this the end?

It happens quickly, it really does.

To get out of this cycle, you have to understand your cash flow.

Cash “feeds” the business. When you have cash coming in at a greater clip than it’s going out, you can:

• reinvest
• fund growth
• pay out dividends

Many think this is profit, but it’s not at all the same. Profit is the illusion of cash, but not actually cash.

If profit and cash flow are divergent, we have to understand why.

So, how do we measure cash flow?

1. Tracking your cash balance
2. Operating Cash Flow
3. Free Cash Flow

Let’s break each of these down and which one matters most for your business.

Tracking your cash balance

No, this isn’t your bank balance. Instead, track your accounting system’s trial balance.

The trial balance takes into account checks written but not cashed, thus represents what your balance would be if everything outstanding hit the account today.

For example, say you have $1,000 in your bank account today (looking at your bank’s online portal). So you decide you can write that $1,500 check because you know you’re receiving some checks in the next few days. Well, your bank will still show $1,000. Now your coworker looks, sees that, and writes a check for $1,000 to a vendor they’ve been waiting to pay. Now you’re negative $1,500 instead of $500! Your deposit was only for $1,250, meaning you’re overdrawn by $250. O no!

But, if you look at your trial balance, as soon as you write the $1,500 check, it will reflect in the balance.

My recommendation is that you use your trial balance and then look at it once a week. To make this balance accurate, you’ll have to make sure all transactions are recorded.

Operating Cash Flow

Operating cash flow is the cash that was generated during a period of time from the operations of the business.

This can be represented on the Statement of Cash Flows. It takes into account:

• Non-cash transactions from the Income Statement
• Changes in Working Capital (AP & AR) on the Balance Sheet

The Income Statement will record sales before you receive the money, so this number helps you see what cash has actually entered the business.

Ultimately, cash drives your business forward. If you don’t generate operating cash flows, your business is having to generate cash from other places which is rarely sustainable.**

Free Cash Flow

Free cash flow is Operating cash flow minus capital expenditures. If you’re in a capital-intensive business, Free Cash Flow confirms you’re generating enough cash to cover the capital reinvestment needed in the company.

A high FCF can be used to:

• pay off debt
• reinvest in the business
• as a dividend for the owners

This really gives you flexibility and consistently high FCF is the holy grail of running a company.

If you don’t have significant capital expenditures, you might not need to track this one.

Value Creation

This is a fluffy term with no clear meaning, so that means I get to make it up.

Here, we want to understand how we value the business and how well that value is doing.

Is your business creating value, thus making you richer?

Enterprise value can be created from profits and cash flow, but it can also be created through asset and liability distribution.

This means we need to look at the Balance Sheet.

So, how do we create value?

1. Revenue is greater than expenses, resulting in profit, or value creation. Not until the cash is collected have you realized this value creation, but it’s “on the books.”
2. Increase in asset values: asset values can go up or down, but buying appreciating assets (ie. real estate) is a great way to create value with little to no work on the back end. You can even LOSE cash throughout the process (because of loan costs) but make it up on the sale.
3. Decreasing liability values: As you pay down debt, assuming asset values are not going down at the same rate, you create additional value.

There are a number of ways to measure it that determine which lever you should pull.

• Return on Assets = Net Income / Total Assets
• Return on Equity = Net Income / Shareholder’s Equity
• Return on Invested Capital = Operating Income after Taxes / Invested Capital
• Return on Capital Employed = Earnings before Interest & Tax (EBIT) / (Total Assets – Current Liabilities)
• Company Valuation

This list is not all-inclusive, either. But, it’s a good start.

What you’re trying to capture with value creation is: is the company that I own going up in value?

Reflecting back on the other 2 legs of this framework (profit & cash flow), when those two go up, the 3rd should as well.

We want to see all 3 legs moving together. When they’re not moving together, you need to dig in to find out why.

We can also view value creation in light of other, external, opportunities. Then we start thinking about overall return on investment, time investment, and scalability.

That’s too much for the scope of this newsletter, but something I’m sure we’ll visit in the future.

While this is overly simplified, I hope this has laid the foundation for better understanding of your numbers.

Please reply to this email with the questions you still have!

The questions you ask help shape what we talk about week-to-week.

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