Important Metrics for Small and Mid-Market Companies — Part 5: Investment

In an average month, my organization explores around 50 companies for possible investment. We review everything from organizational structure, culture, and financial performance, to sales systems, competitive position, and leadership style. This gives us an unusual vantage point from which to recognize patterns of success, and failure.

Getting data is never the problem. In fact for most executives, information can be overwhelming. Getting accurate data and interpreting it appropriately is an entirely different story.

In The Ceiling of Brute Force, we discussed what operational areas impede a company from continued growth. In a series of posts, we’re going to break down 19 of the most important key performance indicators (KPIs), which demonstrate how effectively the business is being run. Think of KPIs as the canaries in your coal mines. If one starts going south, you know it’s time to take a closer look.

Presented in a five-part series, here’s our take on what you should pay attention to, allowing you to focus your time, effort, and dollars. The five parts are: Basics, Customers, Team, Operational Efficiency, and Investment. Investment is our focus in Part 5, including: product development, capital expenditures & depreciation/amortization, total asset base, working capital, and ROIC/IRR.

1. PRODUCT DEVELOPMENT AND THE PIPELINE

KPI Objective: Know what resources are dedicated towards improvement and discovery for the long-term health of the organization.

The effectiveness of research and development efforts can be difficult to measure. Your market may require seasonal product introductions, or you may have a lasting solution with years between refreshes. As such, the information and metrics you track will be highly dependent on your business model.

If your product pipeline is the future, here are a few present-day warning signs:

  • Costs of production: rising production costs may indicate a need to change or diversify materials used, labor sources, or technology employed.
  • Market share: decreasing market share, whether because one competitor has a better market fit (i.e. more features, lower price) or because more players are entering the space, may indicate a need to update existing offerings and/or introduce new products.
  • Customer concentration: as some industries age, they consolidate, creating a scenario where five of your customers consolidate into two; you’ll need to determine how to keep them captive (i.e. expand offerings) or further diversify your client base (i.e. enter related industry).

Knowing your research and developments needs and objectives is a strategic starting point for developing metrics and tracking spending. A Wharton School paper offers up seven R&D areas to consider tracking in terms of spending:

  • Support of current products and services
  • Enhancement and line extension
  • Discovery research required to support desired new target product/market portfolio
  • Development research required to support desired new target product/market portfolio
  • Development and maintenance of technological and management infrastructure required to support R&D activities
  • “Blue Sky” R&D
  • Management of external R&D activities, such as management of licensing

As the paper notes, there are “no normative guidelines… for determining the ‘optimal’ allocation of resources among the seven categories.” It all depends on your company’s needs and priorities.

2. CAPITAL EXPENDITURES & DEPRECIATION/AMORTIZATION

KPI Objective: Know where the business should invest, and when.

In simple terms, depreciation reflects the cost of a physical asset spread over time, as it loses value. Said differently, it’s like getting paid back for past investments. The government allows you to claim tax depreciation of assets on a set schedule by asset type; but, as a general standard, the taxation schedule rarely matches with the lifetime of the asset. Knowing the actual depreciation of assets allows you to budget for when certain items will need to be replaced, or repaired. Most companies use the “straight line” method for calculating depreciation, dividing the initial cost of the asset by what is considered to be its useful life (number of years), and deducting the resulting amount annually. Amortization is similar to depreciation, but accounts for intangible assets (i.e. goodwill from an acquisition, R&D) which typically don’t actually deplete. That’s an important distinction.

Capital expenditures (CAPEX) is the company’s annual spend on new physical assets and are best divided into two categories: maintenance and growth. Maintenance CAPEX accounts for spending required to maintain current operations, including required replacement, or repair, of existing equipment and facility issues. Growth CAPEX accounts for the company’s investment for new initiatives, such as facility expansion.

The trick is to expect the expectable. Equipment breaks. Roofs leak. Investments are a necessary part of operating a business and shouldn’t come as a surprise.

3. TOTAL ASSET BASE

KPI Objective: Understand the current financial state and total investment necessary to perform.

Assets allow you to do business. Fixed assets, like equipment, are the investments necessary to create value, and subsequent profits. Inventory enables you to fulfill customer demand. Cash is, well, cash — it’s the most flexible wealth.

The asset base represents the investments the company has used to perform. It’s a double-edged sword. On one hand, more assets are generally good, like $10 is more than $5. But, if a large amount of assets are required to generate a small return, it’s a poor investment. $1 of profit isn’t equal. It’s what it took to generate it that matters.

4. WORKING CAPITAL

KPI Objective: Know the amount of capital required to operate your company.

Working capital indicates a company’s short-term ability to stay in business, as well as the cash-equivalents required to keep the company “in operation.” It’s Current Assets less Current Liabilities. Therefore, adequate working capital is important, but in excess, can represent issues with cash conversion, inventory challenges, or slow paying customers.

Managing liabilities properly influences the level of cash required, and, in a crisis, may determine whether the company can stay in operation without expensive outside capital.

5. ROIC/IRR

KPI Objective: Know at what rate your company is growing profits.

Most commonly tracked by external investors in a business, return on invested capital (ROIC) and internal rate of return (IRR) can also be useful tools for individual business owners trying to determine both their own levels of return on reinvestment and whether the company may be attractive to buyers.

For ease in explaining the formulas, let’s say you invested $100 to start a company. Two years later, the company has generated $150 of capital that is available for shareholder distribution, and will continue to have profits of $75/year moving forward.

To calculate ROIC, subtract the original value ($100) from the current value ($150), divide the result ($50) by the original value, and multiply that result (0.5) by 100 to get your return in percentage terms (50% — a great return!).

The IRR contextualizes a return by including the time it took to generate the return. A 50% ROIC in two years means something very different than achieving the same return in twenty years.

To calculate IRR, take current cash flow ($150) and divide it by the time value, represented as {(1 + R)^T}, where R is the interest rate on the dollar (for example, 0.5%) and T is the number of time periods (in our case, 2 years). After completing the initial calculation, subtract the original investment ($100) to determine your IRR: 36%.

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Read the other parts of this series:

Brent Beshore is the founder and CEO of adventur.es, a family of companies throughout North America. Read more of Brent’s writings on investing, operating, risk, and not being an asshole. Connect with him on Twitter or LinkedIn.