Discuss: Founders are making a mistake by using financial metrics to gauge startup health

Photo credit: Nik Shuliahin.

Most finance courses for entrepreneurs delve straight into understanding financial statements then dig right into ratio analysis and financial metrics. Ask the Accounting Advisor, a Facebook page I manage that offers free consultancy services to startups, often receives queries from startup founders, presenting me a set of metrics they’ve learned through various financial literacy programs.

What’s the value of a financial metric?

So, what is the value of a financial metric? The value of a financial metric is only relevant when you have a point of comparison. Other than that, there’s none. Yes, it’s a good indicator of “something” that the metric represents, but you need to have a benchmark.

A cash burn rate won’t tell you that you’re doing well unless you compare yourself to a similar company. A gross profit ratio won’t paint a story of financial success for your startup. Your five-year projected growth forecast won’t prove that your business will become successful.

What I’m saying is that we need to stop being addicted to metrics. We love measurable metrics to determine our success and see how we compare to others and where the business is going. But we shouldn’t rely on these.

Why don’t I write about financial metrics?

Startup founders tend to ask me a lot about key performance indicators (KPIs) that they need to look out for. I never tell them to look at financial metrics. It’s not because they’re not helpful, but they are dangerous to untrained eyes.

Let me give you an example. Let’s say a company improved its sales by US$1 million during the year (say a 10 percent increase from the prior year). But, as a result of the additional sales, additional capacity costs have decreased the gross profit ratio (GPR) from 60 percent to 55 percent. For a metric-oriented entrepreneur, this does not look good at all. Costs could have been slashed to maintain or improve GPR. But in reality, the business has actually generated roughly an additional US$550,000 of gross profit during that year. Now the situation doesn’t look all that bad, right?

Let’s twist the story a bit now. Assume that the US$1 million in additional sales actually resulted in an increased GPR (from 60 percent to 65 percent) because excess capacity was used in the production of goods. That seems to be really good, right? But beneath the surface, there is an additional ad spend of US$700,000, which does contribute to future sales. This doesn’t really look great. Your simple ratio analysis might not be able to capture these nuances.

Hopefully, from the example above, you get my point. Financial ratios are only as good as how much you understand the underlying numbers and how you get to where you want to go. Be careful with all the shiny dashboards and easy-to-calculate metrics. More often than not, they’re noise rather than signals.

Let’s discuss:

1. Do you agree that financial metrics are “noise rather than signals?”
2. As a founder, how do you gauge your business health?
3. Can you recommend any courses or programs that can help startup founders understand the impact of financial metrics appropriately?