A company is a complex system. While it may be tempting to focus solely on product development or engineering challenges, getting comfortable with the financial aspects of your company and the key drivers of your business is essential to evaluating its overall health.
Why Financial Literacy Matters
Financial literacy enables you to navigate the complexities of your company, ensuring that every decision aligns with your overall strategy, goals and vision. With a solid grasp of your company’s key financial drivers, you can intelligently evaluate your company’s health to make better decisions, mitigate financial risks and capitalize on opportunities for growth and innovation. Financial literacy also enables effective communication with internal and external stakeholders.
Familiarizing yourself with key business metrics helps you make informed decisions that add up to your company’s success. Here are three key financial metrics you should know.
Total Addressable Market (TAM)
One of the central pillars of financial literacy is understanding your total addressable market (TAM). TAM tells you the overall revenue opportunity available or total demand for a product or service. It can help you understand potential market size, prioritize the right business opportunities and drive long-term growth.
There are three primary ways to calculate TAM:
- Top-down analysis: This approach utilizes third-party research and data to estimate the total market size, then narrows it down to the segment most relevant to a company’s offerings. Think of this visually as an inverted pyramid.
- Bottom-up analysis: This is a more precise approach, using real data about a product’s pricing and usage to estimate demand within the market.
- Value theory analysis: This approach is based on the estimated value a product brings to the consumer and how that value can be captured in pricing. Value theory is best used when launching a new product or service or when cross-selling to current customers.
Accurately calculating TAM can give founders key insights into market potential, drive more informed decision making around product and attract investors. For myself, as someone with a product background, understanding TAM has proved invaluable when interacting with investors and raising funds.
However, while TAM should be an essential component of every business strategy, it’s only an estimation of potential sales and revenue. Use it when introducing a new product or targeting a new customer segment, not as an unerring predictor of outcomes and returns.
Know the Metrics VCs Want to Know
Beyond TAM, it’s essential to know and track the key business metrics VCs are most likely to ask about, even when you’re not fundraising. This includes your cap table as well as metrics such as:
Balance sheet liquidity
How much cash does your company have available right now to cover expenses over the next year? This gives VCs an idea of the potential growth and financial stability of your business, with high liquidity indicating lower risk.
Across every industry and business model, a consistently growing revenue is a strong signal of a product or service that's in demand. It can also help VCs identify internal or external trends, for example management style or product seasonality, that might be influencing a company’s revenue.
Net income or burn rate is a company’s total earnings. This metric gives VCs a sense of a company’s profitability, including how well a company can manage its expenses.
How does your company acquire customers, and what is your cost of acquiring a customer (CAC)? This metric is essential to know because it not only affects profitability — it can tell VCs a lot about your company’s go-to-market strategy and affect their decision on whether to invest. Acquiring new customers shouldn’t break the bank.
Gross margin, or what a business makes after subtracting the cost of goods sold (COGS), gives VCs a window into the fundamental profitability of your business. The higher the gross margin, the stronger the business, indicating a material competitive advantage or unmatched operational efficiency.
Understand Your Sales and Marketing Metrics
For many founders, understanding sales and marketing metrics can be an area of particular weakness. However, delving deeper into sales analytics unlocks possibilities to improve sales and marketing strategies, identify sales trends and refine revenue forecasts.
Key sales metrics every founder should keep tabs on and track against specific revenue goals include:
Annual recurring revenue
ARR, or your total contracted revenue over the course of a year, is an essential KPI for SaaS businesses with a subscription model, as it provides a measure of the predictable revenue you can expect on an annual basis. ARR can also be used to help generate long-term growth forecasts.
This rate measures how many qualified prospects convert into paying customers. Analyzing this rate can provide meaningful insights into your sales process, helping to improve your messaging, marketing and sales strategies, as well as ensure you’re targeting the most relevant customer prospects.
Average deal size
Is your sales team able to land larger deals over time? Average deal size tells you the typical revenue you can expect from each closed deal and, ideally, this number should increase over time as your team sells more expensive products to customers with larger budgets.
For subscription-based businesses, churn rate, or the number of customers who cancel or don’t renew their subscriptions, is a strong indicator of customer satisfaction. By taking a close look at this rate, you can develop strategies to prevent churn with at-risk customers, or identify if something needs to change with your product or service to better meet customer expectations.
Sales productivity metrics
Sales productivity metrics encompass a variety of activities, including the number of emails, calls or meetings per sales rep. This data can tell you a lot about the efficiency and effectiveness of your sales team as well as how engaged your prospects are.
The magic number is an efficiency metric that tells you how much recurring revenue growth is generated for every sales and marketing dollar spent. This number (which should ideally be one) is an essential tool for assessing the effectiveness of your company’s sales and growth strategies.
Deal cycle length
Analyzing your sales cycle length, or the average time it takes to convert an opportunity to a closed deal, is a great way to identify bottlenecks in your sales process that could be delaying or otherwise negatively impacting sales and how to solve those issues to improve your close rate and produce better forecasts.
Win rate, an important indicator of sales performance, measures the percentage of successfully closed deals out of opportunities created. It can also help you determine the sales pipeline coverage needed to achieve your sales targets. Win rate is especially useful when segmented by factors like product or campaign, giving you a more nuanced understanding of performance variations across different areas.
Pipeline generation figures
These figures, including number of new leads, lead conversion rate, sales-qualified leads and pipeline value, provide a clear window into the quantity and quality of potential sales opportunities entering and moving through your company’s sales pipeline. Together, they essentially represent potential future income and can give you valuable insights into how well your sales and marketing efforts are working so you can accurately forecast future sales and implement the right growth strategies.
As you navigate the complexities of running a business, financial literacy empowers you to have meaningful conversations about the financial components of your business. Develop a comprehensive understanding of the financial implications of your decisions and build a strong foundation for your company’s success.