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10 mistakes you're making with financial metrics
(and how to fix them)
For this week’s newsletter we’ve tapped into the wisdom of Finance Twitter (FinTwit). I asked a bunch of my virtual pen pals,
“What’s a common mistake you see people making with financial metrics?”
Here are the 10 best answers.
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1. Putting Average Contract Value (ACV) on a pedestal
Contrary to popular belief, you don't need to sell big deals to Fortune 500 enterprises to be successful.
@InvestiAnalyst believes ACV is really a vanity metric that’s a byproduct of your business model, not a driver of it.
In fact, the world’s biggest and best software companies tend to have smaller ACV’s.
Mongo DB <$25K
Remember: Increases in ACV aren’t free. Usually to increase ACV, it means some other metric of importance gets worse, like CAC.
2. Relying on the P/E Ratio for big companies w/ other income
The price-to-earnings (P/E) ratio relates a company's share price to its earnings per share. A high P/E ratio could mean a company's stock is overvalued, or that investors are expecting high growth in the future.
However, @BrianFeroldi points out how GAAP accounting forces companies to mark up “other income” when their holdings increase in value, and down when their stocks fall.
Other income may include interest, rent, and gains resulting from the sale of fixed assets. The delta can get especially large when there’s a ton of cash on the balance sheet accruing interest or they sell off something valuable. As a result, you can get false signals as to the health of the underlying core operations of a company.
3. Using EBITDA as a proxy for how much money is available to service debt.
Most businesses have maintenance capex. If they don’t spend that capex, the business’s earning power will go down each year.
There’s Growth CapEx and Maintenance CapEx. Think of it in this way - when a company such as Walmart refurbishes an existing store – laying new flooring, painting the walls, replacing cash registers, etc. – it is engaging in maintenance CapEx. Likewise, if Walmart opens a new store, this would be considered growth CapEx.
Per @10kdiver if you want the business to stay alive, what’s actually available to service debt is either:
EBITDA - Maintenance Capex
Cash Flow From Operations + Interest + Taxes - Maintenance Capex
Your businesses needs oxygen. Don't suffocate it.
4. Disregarding the quality of ARPU growth
Many software businesses maniacally focus on ARPU (Average Revenue Per User) and how it grows over time. But overemphasizing growth in ARPU without digging into account retention masks a potentially leaky bucket.
From talking with @AliTheCFO, if ARPU increases, but you’re losing users at a rapid rate, that’s not healthy or sustainable growth.
You’re really on a treadmill and will need to keep spending to acquire new users.
5. Using nonstandard definitions for ARR (Annual Recurring Revenue)
Contrary to popular belief, not all "revenue" is created equal. Multi-year contracts with deep first-year discounting or volume ramps over time drive deltas between the first and last year's ARR.
Many companies will claim the larger, exit year Contracted ARR (CARR) as ARR. But CARR will not track to current period GAAP revenue or billings.
@lukesophinos says using a non-standard definition of ARR can lead to unexpected mark downs by investors during financing events. Re-defining a key metric like your topline growth can cause frustration.
6. Excluding Working Capital from ROIC (return on invested capital)
Many ignore working capital when calculating of ROIC. Working capital includes all the capital wrapped up in current assets and current liabilities (like accounts payable, and accounts receivables).
Depending on the business model there can be a lot of money somewhere in the cash conversion cycle.
According to @MT_Capital1 to avoid overstating returns you should calculate ROIC as:
ROIC = (Net Operating Profit After Tax) / (Working Capital + Property Plant and Equipment)
7. Mismatching revenues and costs when calculating CAC Payback Period
CAC (Customer Acquisition Cost) is what you spend in S&M (sales and marketing) to land a net new customer. And CAC Payback Period is the number of months it takes to break even on that new customer.
Per myself lol @cjgustafson222, S&M costs should be lagged by the average sales cycle of the sales engine you’re measuring. And Customer Support costs should match the current period.
The goal is to align the dollars you spent in the past to generate the sales (ARR) you are seeing today.
Examples of lagging by segment:
Enterprise sales cycle of 180 days = 2 quarter S&M lag
Mid-Market sales cycle of 90 days = 1 quarter S&M lag
SMB sales cycle of 30 days = 0 quarter S&M lag
8. Only measuring Biz efficiency at the Sales and Marketing level
LTV (Lifetime Value) to CAC (Customer Acquisition Cost) measure the efficiency of your go-to-market engine. They shows you how many times over the average customer pays for itself. However, both metrics leave out R&D and G&A spend.
It determines how much the entire company is burning to generate each incremental dollar of ARR and takes into account functions across the entire company, not just sales and marketing.
9. Relying on Accrual Revenue when making growth decisions
Accrual Revenue isn't actually cash. It's a GAAP based accounting view of the world, looking at when revenue should be recognized for services delivered.
Accrual Revenue will almost always lag cash received from new business - cash you can use to run your business today. Common metrics Accrual Revenue lags are both ARR and Billings.
From talking to @KurtisHanni if you make hiring and spending decisions based on it, you can cap growth and leave money on the table.
10. Making bad benchmarking choices
@IAmClintMurphy frequently sees companies:
Comparing themselves to bigger, more established players
Comparing themselves to companies with different monetization models
Looking at metrics in isolation
For eCommerce and DTC businesses @joe_portsmouth says common errors include:
Disregarding the impact of seasonality on conversion rates (Q1 vs Q4)
Disregarding the impact of one-time campaigns and sales on conversion rates (Black Friday)
Disclaimer: Views and opinions are my own. Not financial advice.
Smart Stuff I Read at 2AM
Growth vs Maintenance Capex - e Investing
ACV - Blossom Street Ventures
What I’ve Been Interested In
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Quote I’ve Been Pondering
“If you owe the bank $5 million, the bank owns you…
If you owe the bank $5 billion, you own the bank…”
-Boomerang by Michael Lewis