A Simple Test for Businesses

Simple Business Test | vcfo

A Single Simple Test that Could Save Your Business

Medical professionals often first rely on simple and inexpensive tests to determine whether more expensive, intrusive, or uncomfortable tests are necessary to gain deeper insights or more conclusive evidence to inform medical decisions they and patients face. In many cases, one simple, initial test tells them everything they need to know to make the right call. In business, owners and executives can similarly apply a single, simple test to evaluate and compare a variety of factors and decisions that impact their business.

Below, we examine this test and several ways that owners, executives, and others can apply it.

Converting for Comparability

Business owners and executives are continuously called upon to make decisions and evaluate how well their business and the employees that comprise it are performing. But how does one quickly and quantitatively evaluate questions such as “How do I compare the savings that one employee has generated to improvements that another employee has brought about in another area?” or, “Does it really make sense to move forward with this significant expense we’re considering?”

The first step in getting to an apples-to-apples point is to determine the company’s net profit margin. Let’s say, hypothetically, that it’s 7%. That means that for every dollar of revenue generated, the business ultimately nets $0.07. Now, let’s look at how we can use this number for evaluative purposes:

The CFO reworks the company’s debt stack, which will drive an additional $240K per year for each of the next three years to the bottom line as a result of interest saved. Dividing that amount by the $0.07 net profit margin shows that these savings equate to $3.4M in revenue for each of the three years. Compare that to your sales team or other cost savers.

What this calculation really provides are perspective and context. How does that revenue equivalent compare to what the top salespeople in the company deliver? The number arrived at here is far from the only indicator of job performance, but it does shine more measurable light on the value being delivered. One can also use the same formula on expenses and big-ticket items.

A new, fully equipped route truck would enable more coverage in a service area but would cost the company $200,000. How much incremental sales revenue would need to be generated to pay for it? Dividing the cost by $0.07 (reminder: use your company’s net profit margin, not this hypothetical amount) gives us the answer of ~$2.85M.

Hopefully, the message is getting across that one can apply this same formula or approach in countless ways. Other examples could include evaluating the full effect of HR reducing the cost of benefits by some amount, gains derived from shaving one hour off a process that normally takes eight hours, or even evaluating the relative impact of each of these examples compared to one another.

Additionally, you can also look at it using ANY margin’s perspective. For example, reworking the debt stack generally involves saved principal too, that would happen when you extend your term of the loans on non-revolver debt. That savings in terms of cash flow could be substantially more than just the interest alone. In this case, look at the cash flow margin (i.e., how many pennies at the end of the day do you get to keep for each dollar of sales?)  If the cash flow margin is .12, and the cash flow savings is 460k per year, then the cash flow equivalent in sales dollars terms is $3.8M.

In other words, your CFO can be just as valuable as your best salesperson. Imagine if you started looking at combinations of activities like tax savings, other costs saved/avoided, and then add on the strategic nature of the role.

Imagine if you start making sure that the compensation you pay someone is tied to being able to pay for themselves and then some? For example, if you want to hire a salesperson and they want 175k per year in salary and after you pay the taxes and benefits, it costs the company 200k per year. Your breakeven on this hire is $2.85M. (200/’.07). The higher your profit margin, the lower the breakeven point.

A word of caution, make sure that you are comparing apples to apples by using the same margin when comparing two alternatives.

Add to Your Analysis Arsenal

As with the example of medical testing provided in the introduction, the merits of this simple test in no way should suggest discounting the merits of other formulas that may be more in-depth, complex, or relevant to the given element(s) being evaluated. Think of this test essentially as a confidence check for whether a decision passes muster or a way to view different business elements and outcomes from other angles.

When tendencies to overcomplicate evaluations (paralysis by analysis) or unconscious biases lead to rationalizing ill-fated decisions, a business can suffer mightily. Having this simple formula at the ready enables quick comparability and a powerful perspective that just might save your company from going down a path it can’t recover. To be ready to go with this is simple. A little tracking is in order to know your margins well – add them to your monthly reporting packages for Key Performance Indicators (KPIs).

Would your company benefit from expert finance and HR advice at a fraction of the cost of a full-time senior leader? Request a Free Consultation from a vcfo expert today. We’ve partnered with more than 5,000 businesses in our 25+ years and would love to share our expertise and experience with you.