One of the inherent risks of investing in companies at the earliest stages is revenue diversification which in turn helps to create operating leverage. Most startups we meet are dependent on just a few customers, partners, or channels for the bulk of their early growth. Ideally, these early-stage companies are investing in the business to accelerate and diversify revenue streams.
If executed to perfection, revenues and gross margins are growing faster than operating costs, and operating income (or losses) are increasing (or decreasing) faster than both of them.
But without analyzing a few key metrics, it’s impossible to understand, much less create, operating leverage in the business. Namely, it’s crucial to know how effectively you turn revenue to actual cash and the contribution margin of each product.
Accounts Receivable – How much cash is owed to you?
Accounts receivable is a great metric to use when validating if revenues are “real” or inflated. When I use the word real, it’s in the context that the revenues will become cash in a timely manner. Revenues can easily be inflated by shipping product where payment is not expected or will take a while to collect (more on that in a bit). Rather on purpose or not, in these scenarios cash will be going down while profits are steady and accounts receivable are growing rapidly.
Book to Bill Ratio – How effective are you at turning bookings into real revenue?
Book to bill ratio is simple to calculate by dividing periodic bookings by the same period’s revenues. If bookings are a lot higher than revenues, that can be a positive sign. But it can also mean that your company is having a hard time getting revenue realized, i.e. you have a higher accounts receivable balance than the peers in your industry or at your stage.
Days Sales Outstanding – How effective are you at collecting revenue?
Another easy metric to calculate is days sales outstanding (ending AR/revenue per day) but instead of tracing how efficient you are at converting bookings, it measures how long it takes on average to collect from customers. This number provides insights into where contracts can/should be re-negotiated and also the amount of cash needed to finance your business. One quick note, DSO is an average. For a more granular analysis, be sure to highlight AR under 30 days, 30-60 days, and 90+ days outstanding. This will give you a weighted average which provides more insight into how well the company is actually collecting revenue.
Contribution Margin – Which products/channels are most efficient?
In short, the contribution margin is the window into how each product or channel individually affects the business as a whole. CM highlights what’s available after variable costs to cover fixed expenses and provide profit to your company. It’s as simple as sales minus variable costs and shows the profit on what you sell before fixed costs.
Variable cost is the key factor in this equation – with revenue or channel concentration these numbers are easy to calculate, but with the diversification comes a new equation for each new product or acquisition channel.
Without understanding your CM by product and/or channel, it’s impossible to make informed decisions about where to invest capital for continued growth, the levers that need to be pulled (pricing, CAC, etc..) to make products more profitable, or if products/channels must be entirely eliminated.
This was a fairly long post full of accounting jargon, but it’s important to understand which metrics translate the effectiveness of the business in creating operating leverage. As revenues diversify, these calculations become exponentially more complicated with the addition of new products, customers and acquisition channels. Understanding and tracking them now ensures you’ll have a good grasp on where to allocate new capital when the time comes.