Businesses, Individuals, and Money: The Mirror Image

The media mogul Jay-Z was famously quoted saying, “I’m not a businessman, I’m a business man”. We can’t all be worth a reported $2.5 billion(if you do you can call the office today) but the connotation is that he himself is the business and not this separate entity. Now, you may not consider yourself a business, but financially, there are parallels in how a business operates that you should pay attention to relating to your personal situation. I could dive into an exhaustive list, but I will narrow it down to three categories of metrics that have both personal and business applications: liquidity, efficiency, and profitability.? Let’s dive into each of these further.

“Revenue is vanity, profit is sanity, but cash is king.” - Unknown

Liquidity means how quickly and easily you can get your hands on cash. Although cash is more attractive now, one of the most common questions remains, “How much of my money should I keep in cash?”. Like every good financial answer, it depends. Whether running a big business or managing the paycheck you get every 2 weeks; you will want to keep a certain amount in an account you can access at any time. In the personal sense, we call this your emergency fund. That emergency fund generally needs to be at least 3 months of your living expenses. Conversely, in business, you want at least 2 months of your operating expenses.?

If you’re familiar with the Elements Financial Planning System, the metric you would use to measure your liquidity is called “liquid term,” or LT for short. It measures the amount of assets you have that are considered liquid in relation to your annual spending. So if you have $100K combined in a checking and savings account and spend $100K annually, then your LT score would be 1. Here is a graph that shows a range of scores you can use to assess your current level of liquidity.?

In business, ratio analysis is used to evaluate a number of issues with an entity. Ratio analysis can serve as a check engine light for the company if certain numbers aren’t where you want them to be. A few analyses, such as the current ratio or working capital, are designed to measure how much liquid assets a company has in preparation to pay its short-term and operating expenses. The current ratio is almost identical to the LT metric, just for a business. At the same time, the working capital number will give you the net liquidity you have available after paying short-term obligations.?

The current ratio a business should aim for is 1.5 or more, while the working capital cash amount a business shoots for should be at least 2 months of operating expenses plus the replacement value of certain items like equipment and other factors. For example, if your monthly operating expenses were $25K, and you had $150K in cash with $100K of payables due, you would have a 1.5 current ratio($150K/$100K), and your working capital would be $50K which is 2 months of your operating expenses.?

Whether you're a business or an individual, liquidity is a critical aspect of financial management. It's essential to assess how much liquidity you need, what proportion of that liquidity should be in cash, and what investments can be converted into cash quickly. When it comes to cash, you want to have a minimum level of liquidity and invest the excess amount. You don't have to worry about making the "perfect investment" but instead should invest with the mindset that you won't touch the money and can access it if you need to. This approach can help you maximize your returns while still maintaining adequate liquidity.

We will jump into some other ratios later that can help you determine if you’re keeping too much in cash. Generally, the sooner you begin investing, the better your long-term proposition will be.??

Free Cash Flow vs. Savings Rate:

In the business world, free cash flow (FCF) is the surplus cash that remains after all expenses and investments have been taken care of. This money is available for dividends, expansion, or debt repayment. Similarly, an individual's savings rate shows how much of their income is being set aside for future goals, such as retirement, a down payment on a house, or a dream vacation. A company with a healthy FCF after meeting all obligations signifies growth and stability. It demonstrates that the business is not only operating efficiently but also has a long-term vision and is disciplined in its approach. Similarly, an individual with a high savings rate is not just living for the present but is also securing their future. A high savings rate is a barometer of long-term vision and discipline, indicating that the individual is making smart financial decisions and planning for the future.

By focusing on increasing FCF or savings rate, businesses or individuals can build a strong financial foundation and achieve long-term success.

Efficiency

The financial principles of businesses and individuals are often based on simple concepts such as having more coming in than going out, increasing earnings, and paying oneself first. However, even if you follow these basic principles, it can be beneficial to have certain benchmarks to measure your financial performance. Efficiently managing your money is crucial to achieving long-term financial success. Here is an efficiency metric you can pay attention to.

Return on Equity (ROE) vs. Net Worth Growth:

Businesses rely heavily on metrics to measure their performance, and one of the most important metrics is Return on Equity (ROE). One of the critical decisions a business has to make is how much capital to keep in the business versus how much it takes out to distribute to owners.? When a company generates a higher return on the money that it leaves invested in the business, it is likely to continue reinvesting back into the business for future growth. One way to measure how efficiently a company uses its capital is by comparing its net income to its net worth or shareholder's equity. This metric is called return on equity (ROE).

?For instance, if a company has a profit of $100K and a net worth of $500K, the ROE would be 20%. A large public company would aim for an ROE of 20% or more, while a smaller business would strive for 25% or more. Personally, your yearly net worth growth can be compared to a business's ROE, as it reflects the profit generated by your financial decisions and investments. The higher the growth in your net worth, the more prudent your financial decisions are likely to be. You should aim to grow your net worth by 10% a year. This can be achieved by saving more, getting a good investment return, and reducing your debt. If you take a snapshot of your total assets and liabilities each year, you can set a goal to see your net worth growth increase by double digits yearly.?

Profitability

Gross Profit vs. Debt Management:

One of the key indicators of a business's financial performance lies in its gross profit, which is calculated by subtracting the direct costs from the revenue. This measurement is crucial in determining a company's financial health. Similarly, on a personal level, having low overhead by managing debt is vital to a person's financial well-being.?

A high debt load can stress an individual's finances, just as low gross profit can indicate a company's struggle. Conversely, consistently paying off credit card bills in full, avoiding high-interest loans, and strategically managing student or home loans can help an individual maintain sound finances. This can be paralleled with a business boasting high gross profit margins, indicating sound strategies and minimal wastage.?

In essence, managing debt and maintaining high gross profit margins are crucial to achieving financial stability, whether on an individual or business level.

Savings rate to Consumption(debt + Spending) vs Rule of 40(revenue growth rate +profit margin)

This one is a little more involved, but stick with me. The savings rate we discussed earlier is a common concern for many people. For a rule of thumb of what you should save, you can compare your current savings level to the amount you spend on debt and your lifestyle. Alternatively, you can take your total income, subtract the percentage you pay in taxes, and then subtract the percentage of your income you normally save. Divide that savings percentage by the first calculation. I’ll run an example below for clarity.

Ideally, your annual spending you wouldn’t want to exceed 50% of your income or your debt payments to exceed 30%, while you should aim to save at least 15%. The debt in this context is based on minimum payments. While these are all general targets, a desirable outcome when comparing your savings and total spending (debt + consumption) is a percentage between 20% and 24%.?

For example, if your current annual savings rate is 10%, and you assume your taxes are a constant 20%, then the remaining 70% of your income goes towards your lifestyle spending and debt. Dividing your savings rate of 10% by 70% gives you 14.3%. While this is a solid number, an ideal scenario would have your savings rate closer to at least 13.5% and your spending at 64.5%, giving you a saving versus total spending of 20.9%.

The Rule of 40 is often used to measure the performance of SaaS companies. According to this rule, a SaaS company’s growth rate and profit margin should be equal to or greater than 40%. However, this rule depends on how the revenue growth and profit margin are calculated.?

To calculate a company's revenue growth rate, we typically measure its monthly recurring revenue (MRR) or annual recurring revenue (ARR). MRR is calculated by multiplying the total number of active accounts by the average revenue per account (ARPA), while ARR is calculated by multiplying MRR by 12 months. The growth rate is then calculated by taking the difference between the current year's value and the prior year's value and dividing it by the prior year's value.?

For profit margin, the most commonly used metric is the EBITDA(basically the annual profit a company makes from its operations) margin for the corresponding period. To calculate this, we take the company's EBITDA for a given year and divide it by the revenue for that same year.?

Let's take a simplified example. Suppose a SaaS company generated 10 million USD in revenue in 2019 and 12 million USD in revenue in 2020. Its year-over-year revenue growth would be 20% (2 million divided by 10 million then multiplied by 100%). If the company's EBITDA for 2020 was 3 million USD, then its profitability margin would be 30% (3 million divided by 10 million). In this example, the company's revenue growth plus profitability margin would be 50% (20% plus 30%). This means the company has "passed" the Rule of 40 and is likely well-positioned for the future.?

However, revenue growth and profitability margin could also be negative, especially if the company has recently accrued significant amounts of debt or significant capital expenses. In such cases, the company can still utilize the Rule of 40 and hope that success in one area could offset any issues created by the other.

Moral of the story, if you can’t build a $2.5 billion net worth, all is not lost ??. No matter your current financial situation, you can take actionable steps while paying attention to some key metrics to run your financial life like the most successful businesses in the world. ??