(0:00) Ask questions when the numbers move, because you're not just a founder, you're a builder, (0:05) and builders use measurements to create something that lasts. Welcome to the Margin Method, (0:09) where we document practical strategies and lessons for creating margin, so your business (0:14) generates cash, runs efficiently, and gives you the freedom to lead, scale, or sell whenever (0:20) you're ready. Please share and enjoy.

We've been talking about building systems, managing cash, (0:26) scaling the smart way, not just adding more weight to your business, but actually how to (0:31) scale a profitable business. And today we're going deeper into the financial scorecard (0:36) that every founder needs to understand if you want to, number one, grow profitability, (0:41) two, lead with confidence, and three, build a business that's actually worth something.

(0:47) Right. These are not vanity metrics. They're not for your accountant. They're for you, (0:51) the CEO. So here it is, the five metrics every founder must know cold.

(0:58) So let's go ahead and break them down. Now, look, you don't need to be a financial analyst. You don't need to be a nerd (1:03) like me. I'm a nerd. I'm a financial nerd. You don't have to be a nerd wearing this green shade, (1:07) doing debits and credits in the back office, celebrating when your trial balance sticks in (1:11) ties. Okay. But if you're serious about scaling and eventually stepping back or even selling, (1:18) you have to think like a builder and an investor.

(1:23) So these are the five metrics that tell the truth about your business. Number one, growth, efficiency, profitability, (1:30) cash generation, and value creation. So if you've ever stared at your financials and thought, (1:36) I have no idea what I'm looking at. This episode is for you.

(1:41) And let me just say this. When I was 16 years old, I started my first company. It was a landscape design build firm. (1:45) I didn't know it was going to grow into a multimillion dollar company. And guess what? (1:49) Here I was running this business. I was just a young little boy and I had no clue how to read (1:55) financial statements. I mean, my accountant would give me the P and L and I'd look at revenue and (1:59) profit, but yeah, everything else in between, I had no clue what those numbers meant.

(2:04) So if that's you, hey, no problem. Just don't stay there. All right.

(2:09) Let's talk about metric number one, revenue growth. Are we actually growing? That's the question here.

(2:15) This one seems obvious, but don't take it at face value. You want to ask number one, how fast are you growing (2:20) month over month, year over year? Number two, where's the growth coming from? Which segments, (2:27) customers, divisions, geographies, et cetera. And is it healthy and actually repeatable?

(2:33) So let's say you went from 2.5 million to 3.2 million in one year. That's 28% growth. Great. (2:41) But was that driven by discounts? Was it profitable growth? And these are things to (2:47) consider, right?

(2:47) So check this out. You should watch for number one, consistent growth. It should (2:52) be greater than big jumps followed by big drops. So if your revenue is all over the place, like (2:57) it goes up and it goes down, up and down, it's going to create schizophrenia in you because (3:01) you're going to be cheering on the sidelines. And then you're going to be like depressed the (3:05) next month because your revenue is all over the place.

(3:11) So consistent revenue is really important. Stable revenue is good, especially when it comes to building a business that is worth something (3:17) and sellable. Okay. Because investors are going to want to buy a business with that consistency.

(3:23) All right. Next, growth from core offers should be greater than these one-off windfalls. So that's (3:31) how you're going to scale your business successfully — your core offer should be consistent and stable. (3:37) Otherwise you're going to have these big jumps by one-off sales and that can hurt your business.

(3:42) All right. Next, growth with gross margin should be greater than growth that eats profit. So those (3:49) are some things that you're going to want to look at when you're evaluating that first metric — revenue (3:53) growth.

(3:53) All right. Let's talk about metric number two, gross profit margin. Are we keeping enough (3:59) of what we sell? That's what it comes down to.

(4:06) Now, gross margin or gross profit — the same thing — can be calculated by taking revenue minus your cost of revenue, right? Your cost of goods sold, (4:13) COGS, however you want to look at it, divided by your revenue.

(4:19) So revenue minus your cost of revenue divided by your revenue. If you bring in $1 million in revenue, let's say, and it costs you $600,000 (4:25) to deliver on that revenue — material costs, direct labor costs, et cetera — (4:30) then your gross margin is going to be 40%.

(4:36) This matters because gross profit funds everything else. It funds your team, marketing, rent, and hopefully your profit.

(4:43) So if your profit margin is too tight, it doesn't matter how fast you're growing. You'll always feel like you're chasing (4:48) your tail.

(4:55) All right. Here's a pro tip for you. If you can, break your gross profit margin down by product or service line. Because if you do this, you might find that one offer carries (5:01) the business. And then the other offers or the other products and services that you're selling (5:06) are actually draining resources. And then you can modify your product offering and make your (5:11) business more profitable.

(5:18) But gross margin — super important to measure. Number three is operating profit margin. Are we running a financially sound business? That's what you're trying to figure out.

(5:24) Operating profit margin can be found by taking operating income divided by revenue. The key word is operating.

(5:30) So when you look at your profit and loss statement, your income statement, you don't want to just look at net income. You want to look at your operating profit.

(5:39) So that's above net income. In other words, you want to look at how much profit is your business generating from normal operations, the core operations of the business.

(5:48) So let's say your company is bringing in $4 million and your operating profit is $600,000. (5:55) So if you take that 600,000 divided by 4 million, that's a 15% margin, which is strong.

(6:01) This tells you how well your business is run, not just how much you're selling.

(6:07) In the average profitability in the United States, any guesses? How much do you think the average profit is for a business profit margin? It's 7% to 10%.

(6:21) So I always tell my clients, 10% is the standard. You should be earning a 10% margin on your business. And then anything above that is gravy.

(6:26) Now it depends on your industry. When I was a CFO of a construction company, our margins, our net margins were 2% to 3% because construction is super low margin. We're very thin.

(6:41) But also you could be in the construction industry and let's say you're a trade business like a plumbing or a landscaping business, your margin may be 10%, 12%, 15% or higher.

(6:51) So it just depends on what industry you're in. So I'd definitely benchmark yourself, but just as a good rule of thumb, a 10% operating margin is kind of the benchmark to exceed.

(7:03) So the reason why operating profit margin matters is because this is the margin that buyers, banks, and smart investors are going to be looking at.

(7:09) Also, it reflects your ability to turn revenue into real results. Because if you're not earning an operating margin, there could be problems with your pricing, with your volume, with your cost efficiencies, with your cost for goods sold, or maybe your overhead's too high.

(7:25) So it reflects your ability to actually turn revenue into financial tangible results. And if it's consistently low, or it's trending downward, you're growing inefficiently.

(7:38) That's what needs to be fixed. Like I said, ideally you want to see operating margins improve as you scale, because that represents true leverage.

(7:49) All right, let's get into metric number four. How much cash are we actually generating?

(7:56) You could be profitable on paper and still be broke in real life. That's the sad thing. Because remember, profit doesn't equal cashflow.

(8:01) I just did an episode a couple of episodes back. Make sure you check that out if you want to learn more about this.

(8:05) But free cashflow is my baby. I always talk about free cashflow because here's a stat: 70% of companies that go bankrupt are actually profitable when they close their doors.

(8:15) Meaning they have profit on their income statement, but they don't have free cashflow.

(8:20) All right, so free cashflow can be computed by going to the statement of cash flows and finding cash from operations — that's the first section — and subtracting out capital expenditures, CAPEX for short.

(8:31) Capital expenditures are found in the investing section on the statement of cash flows.

(8:37) This is the amount of cash that's left over after your business covers its basic operating needs and reinvestments.

(8:43) In other words, free cashflow represents how much cash you have available to pay down debt, return to equity providers, and reinvest in your company.

(8:55) It's all about cashflow. Okay? And here's why it matters.

(9:01) First, it shows you how much you could pay yourself or use to reduce debt, like I just mentioned. It's what makes a business self-sustaining and it's a major factor in valuation — free cashflow.

(9:13) So you're going to want to pay attention to it for sure.

(9:13) So let's say you generate $850,000 in operating cash and you spend $250,000 on equipment upgrades and tech. That's your CAPEX, capital expenditures.

(9:26) Your free cashflow would then be $850,000 minus that $250,000 or $600,000.

(9:34) And that's what gives you breathing room, buffer, and optionality.

(9:40) So if free cashflow is always tight, even when profit looks good, that's a serious red flag.

(9:46) Okay. Metric number five, return on invested capital. I love return on invested capital.

(9:46) I wrote a book called Cashflow recently. By the way, as of the date of this recording, don't hold me to this if I change my offer later on, but you could go to coltivar.com.

(9:56) You could get the book for free if you live in the continental U.S. and you cover shipping. I'll pay for the book and the printing of the book, everything else. You just cover shipping. That'll be the deal.

(10:04) But in the book, I talk about return on invested capital a lot. In fact, that's the central theme of the book.

(10:09) So if you're not familiar with that, be sure to check that out, or it's even on Audible if you want to just listen to me.

(10:13) Okay. But return on invested capital, ROIC, helps to measure this: Are we getting a return on what we're putting into the business?

(10:27) That's the question it answers. So this is the big picture value metric.

(10:33) An ROIC can be calculated by taking net operating profit after tax, NOPAT, divided by invested capital.

(10:40) Now, before I give you an example, you may be wondering, okay, well, that's great. You're talking about net operating profit after tax but if you're in the United States and you're operating an LLC or an S Corp, your LLC or S Corp doesn't pay taxes, right? Instead, it's a pass-through entity, and you pay for the taxes through your K-1 and through your personal income taxes.

(11:02) So the way I like to look at net operating profit after tax in the portfolio companies that we work with is I'll just take 35% as an effective tax rate across all companies.

(11:06) The reason why I do that is because every individual owner is going to have a different tax basis, right? So they're going to have just a different effective tax rate. So therefore, I just use 35%. It's close enough.

(11:24) And then what I do is I take that operating profit that we were just talking about above. So I'll take that operating profit, and I'll multiply that by one minus the tax rate — one minus 35%, okay, or 0.35.

(11:34) And that's how I come up with my net operating profit after tax. And then I divide it by that invested capital, okay?

(11:41) Invested capital is a combination of your working capital, which can be found on your balance sheet, and your net property plant equipment.

(11:52) So let me give you an example. Let's say your NOPAT is $900,000, and your invested capital — your working capital and your net PP&E — is 4.5 million.

(11:59) That means you have a 20% return on invested capital, which is really good.

(12:06) So think about this. There's a rule in finance. It's called the rule of 72. I didn't come up with the number. That's just what it is.

(12:12) But if you take 72 divided by your return, your average return, it'll spit out a number which indicates how fast money doubles.

(12:25) So let's just say with 72, you divide it by 10 for a 10% return. That means that your money's going to double every 7.2 years — or seven years if we round it.

(12:32) So at a 20% return on invested capital, if you take 72 divided by 20, that means your money's doubling every three and a half years.

(12:44) Okay, that's good, right? That's how you can compound wealth.

(12:50) Just remember, in the stock market in the United States over the last like 50 years, it's returned on average like 9% to 10%.

(12:55) So if you do the math and your return on invested capital is below that 9% to 10%, it doesn't mean you should shut down your business and just go spend all your money on Apple or Google stock.

(13:12) Instead, it just means that you're earning below average returns for what you should be as an equity provider. So this is a really important metric to measure.

(13:19) You can't get this number just by looking at the income statement. You have to blend the two — the income statement and the balance sheet.

(13:22) But return on invested capital, you're going to hear me talk about it a lot. Super, super important.

(13:26) So this metric answers this question: For every dollar we put in, what do we get back?

(13:33) It's what private equity firms, sophisticated buyers, and high-level CEOs use to evaluate how well the business is performing as an investment.

(13:45) So high ROIC means this:

• (13:45) Number one, you're efficient with your capital. That's good.
• (13:51) Number two, you're allocating resources smartly, which goes back to strategy. Strategy is all about allocating resources.
• (13:57) Number three, you're building compounding value, not just growing revenue.

(14:02) So let's run through them again, just as a recap:

• (14:10) Number one, revenue growth — are we gaining market momentum?
• (14:16) Number two, gross margin — are we delivering efficiently?
• (14:22) Number three, operating margin — are we running a disciplined, profitable business?
• (14:22) Number four, free cashflow — do we have actual money, like cash, to reinvest or reward ourselves?
• (14:29) And number five, return on invested capital — are we creating real return on everything we built?

(14:36) So you can think about these as the founder's scoreboard.

(14:43) And you don't need to necessarily memorize the formulas, but you do need to know your numbers.

(14:49) When you do, you can make better decisions, you can catch red flags early, and you can focus your energy on what truly moves the needle.

(14:55) So let me give you a real example before we wrap up.

(15:01) Two businesses I worked with were both doing around $10 million in revenue.

(15:08) Company A had a 30% gross margin, 12% operating margin, barely broke even on free cashflow, and had a 7% return on invested capital.

(15:14) Company B, on the other hand, had a 42% gross margin, 20% operating margin, generated $1.5 million in free cashflow, and posted a 28% return on invested capital.

(15:30) See, that's the crazy thing. Same top line, wildly different bottom line in value.

(15:36) And guess which one attracted buyers and got a premium multiple? Yeah, company B. Because smart money doesn't chase revenue — it follows value.

(15:41) That's the key, okay?

(15:47) So if you're not already tracking these five metrics, that's okay. Start this month. Just start. You'll be amazed how quickly it sharpens your focus.

(15:52) So you could do this by creating a simple dashboard or a spreadsheet. Review it monthly.

(15:57) And most importantly, ask questions when the numbers move. Because you're not just a founder, (16:02) you're a builder. And builders use measurements to create something that lasts.

(16:06) And if this is not for you — if you're like, oh my gosh, this hurts my head, Steve, just thinking about metrics is just not your thing — that's totally fine.

(16:15) Like, I've worked with a lot of companies where the founders recognize that finance isn't their strength. And perhaps they have a bookkeeper or they have a controller on staff, but they don't have a CFO to help them really understand the numbers.

(16:23) This is where we can help. I mean, you could always reach out to us at Coltivar, and my team can work with your business to show you how to put in place KPIs and create a dashboard for you.

(16:33) And it's just plug and play. Then you have a dashboard, you're all set to go, and you can start measuring this stuff right away.

(16:43) Okay, so if you're interested, go to coltivar.com.

(16:46) All right, just a heads up — next week, we're digging into a big question: Is your business actually sellable?

(16:52) We'll break down what buyers look for, what kills deals, and what you can start fixing right now, even if you don't plan to sell.

(17:03) Until then, subscribe if you haven't, and be sure to share this with a founder who's tracking revenue, but they're missing the deeper story.

(17:08) And if you want help building a metrics dashboard, remember, you can always message us at coltivar.com. I got plenty of tools for you.

(17:14) All right, keep going, keep leading, and remember — the business you're building can set you completely free, if you build it the right way.

(17:24) All right, I'll catch you on the next one. Take care of yourself. Cheers.