Are we using the wrong metrics to assess business success?

So often we hear or see something in the media about a particular business that has “made it”. Usually, it’s a fast growing start up business that has grown out of someone’s garage into a “multi-million dollar business”.

Sorry to be the bearer of bad news – but it is usually NOT a “multi-million dollar business”.

As a society, we seem to have this obsession that the business value is somehow the same as its sales volume. In other words, a business turning over $3m is somehow a $3m business, implying that it is worth $3m. This is rarely, if ever, the case.

In my opinion, this focus on sales (and not true business value) is one of the factors influencing many business owners to chase volume (or sales) at the expense of building a sound, sustainable business over time and why we continue to see business failures reported on an almost daily basis.

It will therefore come as no surprise that my key measure of business success is business value, not sales volume. It therefore follows that every decision a business owner makes should be predicated on building long term business value. Sometimes this may be contrary to sales growth. For example, it is easier to build sales if you simply discount your prices. You’ll have higher and higher sales, but less and less profit. In my experience, this is a downward spiral to the bottom.

On the other hand, adopting a premium pricing strategy and differentiating your product may actually result in slower sales growth. This is not a bad thing. Your sales growth needs to be sustainable. However, if your cost of product remains unchanged then clearly you will make more profit under a premium pricing strategy than a price discounting strategy.

This raises an interesting point. How many business owners actually measure and manage their business value on a regular basis – say yearly? How many actually develop strategy based on whether those strategies will increase the business’ value? How many know whether a particular strategy will increase or decrease its value?

From my 30-odd years of experience, the answer is very, very few. Everyone measures sales and everything else in the financial statements but very few measure their business value and whether they have added or destroyed value in their business.

How to determine my business value?

In its simplest form, business value is added when the business makes a return (on capital employed) greater than the cost of the capital invested in that business.

The capital invested in any business has an opportunity cost. If that capital wasn’t invested in that business it could be invested in another business, in publicly listed shares or in interest bearing deposits in the bank. Either way, that capital would get a return relative to the risk taken with the various investment classes. When you choose to invest your capital into a business you need to ensure that you’re getting an appropriate rate of return reflecting the risk taken. If your rate of return is less than the rate you need to compensate you for the risk on investing in that business, then you’re destroying value, not building value.

So why the predisposition with sales turnover?

In my view, it’s simple – sales feed the ego of the owner or CEO and it’s an easy metric to pick. It is also implicit that if sales are growing, the business must be doing well. Wrong! Look at the corporate collapses in recent months and you’ll see quite a number that have been “fast growing”. I would say, growing too fast.

So, before you get excited (and envious) about some fast growing business you may see reported in the media, ask a simple question – what was their return on capital employed? This is the true measure of business success.

Business owners need to constantly ask themselves the question: “Is my business decision adding value or am I destroying value?”

MGI works with our clients to help them regularly measure the value of their business and strategies to improve this.

The information contained in this article is general in nature and readers should seek their own professional advice in relation to these areas. MGI refers to one or more of the independent member firms of the MGI international alliance of independent auditing, accounting and consulting firms. Each MGI firm in Australasia is a separate legal entity and has no liability for another Australasian or international member’s acts or omissions. MGI is a brand name for the MGI Australasian network and for each of the MGI member firms worldwide. Liability limited by a scheme approved under Professional Standards Legislation.