Growth can be a double-edged sword for startups. While it brings revenue and opportunity, it also means increased operational complexity that can go awry if founders don’t track the right metrics and use them to guide operations.
But these metrics only become useful if they are properly tracked and used to inform business decisions.
Ali Ladha, a virtual CFO for startups & SMBs through his company Vertical CPA, talks about these problems regularly on his Twitter and YouTube channels. In viral tweet threads and various YouTube videos, Ladha explains the financial metrics every business owner should know, how to calculate them, and how they connect to operational decisions.
Why early-stage founders struggle with operations
“Typically, when a founder starts a business, she doesn’t need to write down steps for any task or keep track of any documentation,” said Ladha.
But Ladha cautioned that things get significantly more complex once founders make their first hires. At this point, Ladha noted documentation becomes essential since that new hire “can’t get inside your head” to figure out day-to-day processes. However, this is also the time when the business (hopefully) gets busier—meaning founders are now delivering on their own work, managing a new person, and looking to grow the business further to support additional salary.
“If you want to grow your company into a real business, you need to start documenting procedures so that you can start to delegate tasks to your team,” said Ladha.
These compounding responsibilities, on top of the businesses’ increasing financial complexity, are why founders struggle, said Ladha. Unfortunately, during this phase, it’s easy for things to fall through the cracks. One common problem area is finance, particularly if the founder doesn’t have a strong finance background.
Critical financial metrics to track
Ladha explained what he feels are the top eight metrics every founder must track—the metrics that not only tell you about the financial health of your business but also give you insight into operational efficiency.
1. Fixed costs
Fixed costs are the sum of all expenses that happen regardless of whether you have customers or product usage—for example, office leases or coworking spaces, salaries, and digital infrastructure costs like basic hosting.
2. Variable costs
Variable costs are what you spend to service your customers and usually change based on sales. For example, your core hosting is generally a fixed cost. But if hosting costs go up because a new customer is heavily using the product, the difference is a variable cost.
Ladha pointed out that key variable costs depend on the type of business you run: with e-commerce, it’s usually inventory, and with software, it’s usually salaries.
Break-even is a calculation of how many units of your solution you need to sell before covering costs in a given period.
In a SaaS business, for example, you might have a one-year budget that includes salaries, marketing, digital infrastructure, office space, and various hardware and software costs.
Then you’d have the average contract value of your solution. Adding up all your expenses and dividing the total by the annual cost that customers pay tells you how many customers you need to close in year one to hit your first dollar of profit.
While many startups are not profitable in year one (or for multiple years), knowing your break-even number is essential for tracking your path to profitability and for fundraising. It also shows you where you might be able to reduce expenses to hit break-even faster, an essential element in turbulent markets.
4. Gross profit margin
Gross profit is whatever is left over after covering all costs to generate revenue, whether that’s advertising costs, costs of goods sold, or payroll for employees to create or market your solution. Ladha said gross profit is often used to gauge the health of a business since it signals the costs to earn revenue are low and there’s money left over to cover the other expenses of the business.
5. Net profit margin
Profit margin shows how much of your revenue is converted into profit after paying all expenses. Ladha added that another way to think about profit margin is how much profit you make per dollar in revenue you bring in.
Calculating profit margin requires taking your net profit (any money left over after all expenses are paid) and dividing it by your total revenue, resulting in a percentage.
6. Sales growth
Ladha said understanding sales growth is critical because earning more revenue cures the majority of a business’ problems. Calculating sales growth requires choosing a period of time—week to week, month to month, quarter to quarter, and year to year are common periods—and comparing that chosen period to the previous analogous period.
While a lagging indicator, measuring sales growth over time can show a trend line that gives founders the opportunity to preempt further issues. For example, if you notice sales growth has slowed for three periods of measurement, you can take action to bolster the fourth period and reverse the downtrend.
7. ARPU (Average Revenue Per User)
ARPU shows you how much money each customer pays you, an important metric to understand because it informs how you have to set up your cost structure and marketing efforts. For example, a low ARPU might suggest a mass-market approach with a low-cost business structure to ensure gross and net profit. A high ARPU, on the other hand, might mean bespoke or high-touch sales efforts can still be profitable.
In any business, ARPU is calculated as the sum of all customer-derived revenues (i.e., not including any financial gain such as interest paid on bank deposits) divided by the number of customers.
Ladha said the easiest way to increase ARPU is to raise prices—when Netflix raised its prices in 2022, the company’s ARPU went up because all customers ended up paying more.
It’s important to note that ARPU is not always correlated with higher revenues or profits. If you increase prices to a point that angers customers, you could experience significant churn that reduces your overall revenue. However, if part of customer churn also meant a significant reduction in variable costs, it could still be a profitable move.
8. Burn rate
Burn rate is how much a company spends over a given period: the sum of all regular outgoings (e.g., salaries, subscriptions, etc.) and of any amortized lump sum payments (e.g., a loan that you pay back in regular installments).
You can also compare burn rate to revenue coming in by looking at cash balances at the start versus the end of the month. If you have enough revenue coming in to offset all expenses, you have a negative burn rate (meaning you’re cash flow positive for the period).
Ladha cautioned that founders need to keep a close eye on burn rate because it can spell disaster if a business blows through cash too quickly. To illustrate this, he shared the example of Fast, the much-beloved e-commerce startup that raised $125 million in November 2020 but had to shut down by May 2022. According to Ladha’s calculations, that meant Fast had a burn rate of about $7 million per month during that period.
Know when it’s time to get help
The eight metrics above provide a comprehensive overview of your business, showing how much money you need to stay afloat, the source of your expenses, and how quickly your revenue is growing.
But these metrics only become useful if they are properly tracked and used to inform business decisions. As the complexity of their business increases, founders cannot ignore these metrics. Doing so can lead to bad decisions—based on incorrect or incomplete data—that could harm the business.
If your business struggles with the process of achieving or acting on financial visibility, it might be time to get help. While every business is unique in some way, Ladha suggested a couple of instances where getting help is necessary: if you find yourself having to work late or on weekends just to catch up on administration or financial documentation is the first instance. The second is when the cost savings of not outsourcing tasks outweigh the financial benefits of the time freed up. For instance, Ladha said if founders save $500 a month on bookkeeping by doing it themselves but those hours could have been used to land a $2,000 per month client, it’s time to outsource.
Ladha also noted outsourcing is, in a way, a rebuke of hustle culture, which he said initially seems admirable but is ultimately damaging to long-term growth prospects.
“Your job as a founder should be focused on growing your business,” said Ladha. “The classic founder mentality is to try to save a few hundred dollars by not outsourcing or delegating. However, that’s missing the point.”
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Photo courtesy of Nappy.