Written by contributing writers Amol Maheshwari and Shweta Jhajharia
You’ve probably heard the famous quote by Abraham Lincoln: “Give me six hours to chop down a tree, and I will spend the first four sharpening the axe.” This simple wisdom applies to any endeavor, but especially to running a successful business.
Many business owners start their ventures without investing enough time and effort in sharpening their most important tools: their knowledge of how to run a good business and their ability to make smart decisions that will save them time and money. They end up on a never-ending hamster wheel of stress and struggle, always short of time and money. This problem is more common in the SME sector, where most business owners lack formal management training.
That’s why we are passionate about working with SMEs because we have seen the amazing results that can be achieved when knowledge is combined with hard work and ambition. When you increase your knowledge, you can ask better questions and gather relevant information that helps you make better decisions. Better decisions lead to higher chances of success and growth and create a compounding effect that sets you apart from other businesses that rely on luck or trial and error.
The Importance of Measuring Your Performance
However, many business owners neglect one of their most important responsibilities: measuring their own performance and progress. They don’t define their own key performance indicators (KPIs) to track how well they are doing. One of the most critical KPIs for a business owner is the optimal allocation of resources in the business – of which there are two – capital and labor. While most business owners are constantly thinking about who is doing what and how well, they often forget about the other resource – capital – and how it is being used or wasted in the business. The core purpose of every business is to create value, and this depends on how capital is allocated and what return it earns. This is reflected in the financial scorecards of the business, the profit and loss statement, and the balance sheet. Every good or bad decision on capital allocation shows up in these financial statements.
The statistics are sobering: 61.5% of businesses in the UK don’t survive past their fifth anniversary, according to ONS data. The most common reasons for failure are poor cash flow management, sometimes caused by overtrading, and poor decision-making by the business owners due to a lack of skills and knowledge required to operate a business. Moreover, according to ONS 2021 data, out of the 5.6 million companies in the UK, only 312,000 reported a turnover of over £1M – implying that even if business owners manage to survive, they are likely to be in the 94.5% of businesses that don’t reach the £1M revenue threshold.
These statistics reveal the direct correlation between the growing complexity of a larger business and the ability of an untrained business owner to manage and continue to grow it. One of the key skills required to manage this complexity is the constant process of simplification through eliminating what’s not working and focusing on what’s working in the business. And the most important metrics that guide these decisions are financial metrics.
How Financial Metrics Can Help You Make Better Decisions
We had a client who faced two seemingly similar opportunities. One had an expected profit of £50,000, while the other had an expected profit of £60,000. The client only had the resources to take on one project and thought it was an easy decision – it was, but not based on just these numbers. It turned out that they would have to invest £100,000 for the first project and £150,000 for the second one to deliver successfully. This meant that the return on invested capital (ROIC) on the first project was £50,000/ £100,000, i.e., 50%, whereas on the second project was £60,000 / £150,000 i.e.40%. While both returns were above the company’s cost of capital and, therefore, value creation, it would have taken the wrong decision if simply looking at the net profitability of the projects.
In another instance, a client had to choose between a 19% ROIC project and a 20% ROIC project. The key difference in this case, however, was that the first project gave them the ability to use debt financing, whereas the second one did not. This meant that the ROE (return on equity) on the first project was 40% against the ROE of 30% on the second project, making it a lot more value-creating for the business owner. In both cases, a simplistic understanding of financials – we need to make more profit – was inadequate for better decision-making. While these decisions were not make or break for the businesses involved, they were examples of how consistent good or bad decisions can determine the long-term fate of any business. Business owners need to start using their scorecards as guides for decision-making, understanding the return and the costs associated with their actions, and therefore consistently trying to maximize value creation.
How to Optimise Your Most Important Resource – Time
Equally, for their most important resource – time, they need to consistently make decisions that maximize the returns that their time gives to the business. For one of our clients, their profit every year was £200,000, and the business owner was routinely putting in 70-hour weeks and had not been able to take time off in the last couple of years as the demands of the business kept increasing. A simple calculation indicated that he was earning £400,000 every year on a time commitment of 3,640 hours (70 hours over 52 weeks) and, therefore, around £55 per hour. We decided together to identify all tasks he was doing that were less than £25 an hour jobs and hired an assistant to take them over. We also decided that he needed to refocus on the highest per-hour activities in the business – which, in his case, was focused on large-value sales. In just under a year, the business owner was no longer ‘time-poor’ and making significantly more money than he had been when working non-stop.
The language of business is numbers, and entrepreneurs who have decided to spend their whole lives in business need to take time out to sharpen their axes – and learn this language of business to make better decisions and escape from the constant state of being time and money-poor.
About the authors:
Amol Maheshwari is the Managing Partner and M&A head at Growth Idea. Shweta Jhajharia is a leading global business coach and founder of Growth Idea. Their new book Score is the ultimate handbook to help SME business owners and senior leaders master the fundamentals of finance in order to propel them towards unprecedented success.