Business Formulas and You: A Love Story

Formulas Are Good for You

Do you remember that scene in Good Will Hunting where the teacher writes the unsolvable math problem on the chalkboard? His top students twist their brains into knots trying in vain to crack it. And other students (i.e., English majors) probably vomited immediately upon seeing that complex array displayed in the hallway.

Then along came a quiet janitor with an impressive jawline. Will, bless his heart, was able to crack the code. He simultaneously solved the problem and triumphed over the academic bourgeoisie.

Chances are high that you aren’t a handsome janitor played by Matt Damon in a fictitious film, so you probably won’t be solving impossible math problems. But that doesn’t mean you should turn your back on formulas. Trust me—they can be really helpful.

At their core, formulas are simply rules that get you from point A to point B. They’re written with mathematical symbols, but the logic behind them is so rock solid that they can also be described in words.

For example, let’s say the formula is (A + B) – C = D. That might look a little intimidating to some of us. But if you were telling a friend about it, you could just say, “Oh, you’re trying to figure out D? Just add up A and B and then subtract C. It’s super easy!”

The inimitable Julia Child understood that formulas were more than just chicken scratch. Rather, she knew they could be used to make a delicious chicken dish from scratch. Each formula was a series of steps that allowed her to build a culinary empire one meal at a time.

“When you have a few cake formulas and filling ideas in your repertoire, you will find that it’s pretty much an assembly job,” she once said. “You can mix and match a different way every time.”

Whether you’re a baker working on a cake or a small business owner trying to calculate your profit margin, formulas can help you reach the best result with the least amount of stress possible.

Formulas Are Good for Small Businesses

Let’s now talk about you and your business. Just as every Julia Child dish was unique in its own way, your small business is truly one of a kind. Sure, the competitors in your industry do some things similarly. But none of them have the exact makeup as you—nor do they carry out their operations exactly as you do.

Because you’re so unique, there’s no silver bullet when it comes to business formulas. There are essential formulas that every business needs to understand and use, then a wide array of ancillary formulas that you can apply when and where you see fit. Each brings its own clarity, allowing you to build a repertoire of formulas that are uniquely suited to your business.

Many of the most popular formulas are used to identify key performance indicators (KPIs). These little nuggets of information help you more accurately measure your business’s performance. Individually, they can be illuminating. Viewed together, they provide the type of clarity needed for accurate budgeting and bold strategizing.

“Big businesses have been using KPIs to measure their success for years,” says business expert Tim Clairmont. “Yet many small businesses ignore this less-understood acronym. Employees can measure their success by comparing the results of their KPIs over time. A manager can see if an employee is improving and if they are outperforming other employees by looking at their KPIs and tracking their results. But if you are self-employed or running your own firm, who is there to tell you what your KPIs are? Are you letting your business run you, or are you running your business? Moving from salesperson to businessperson or moving from a small business to a larger business requires a change in perspective. And one great place to start is to figure out your KPIs.”

Various business formulas give you the ability to track your progress, so you have the opportunity to make more progress. It’s all about measuring results so you can fix what isn’t working and double down on your strengths.

Formulas Are Good for Goals

It’s obvious that formulas alone won’t accomplish anything for your business. If Julia Child made a goal to serve the most incredible roasted duck that the world had ever seen, her recipe wouldn’t have been able to do any of the actual work. It would just sit there on the counter—she used quality ingredients and her unique talents to create the exquisite dish.

Your business goals work in the same way. Business formulas are crucial accessories that help you gauge where you are and where you need to go. They don’t replace the need for hard work and careful planning.

Armed with the information you derive from your favorite formulas, you can chart the path ahead. Each business goal should be measurable, actionable, relevant, and beneficial for your bottom line.

Let’s say you want to increase your online business’s visibility in your city in an effort to boost local sales and save money on shipping costs. Here’s a less effective way to outline that goal: “We want to get more sales in our town by the end of the year.”

To improve the measurability of the goal, you could change it to: “We will increase sales in our town by 30% by the end of the year.”

To make it actionable, you would need to come up with tactics. Perhaps your research indicates that geo-targeted display ads would be highly effective. And you might also realize that your business could co-sponsor city events, introducing your brand to a whole new audience.

You would ultimately want to select a number of KPIs for this initiative, and formulas would enter the picture as you tracked your progress and refined your approach.

“In my decade as CEO of a digital marketing agency, I’ve never met a company yet that succeeded in creating a refined digital marketing campaign without first coming up with equally effective key performance indicators for the strategies,” says entrepreneur Oganes Vagramovich Barsegyan. “I’m absolutely convinced that the key to choosing KPIs is to contextualize them with your business. You must match them not only to your goals but also to a host of other factors, such as your strengths and weaknesses and the life stage of your business.”

It’s time to ask yourself how your business can improve. What data could you benefit from that you don’t already have access to? This is where formulas can show their true colors and help reduce guessing games and increase your accomplishments.

Formulas to Know

The following formulas represent a cross-section of the possibilities out there. Some will be relevant to your business, others less so. Take the time to consider your blind spots and then find relevant formulas that can help to shine a light on them.

Net Income

If formulas were food, this one would be your bread and butter. Net income reveals if your business is bringing in more money than it spends, which is the simple dream of all entrepreneurs. The efficiency and growth of your business shine through in this stat, which is why lenders and investors are often keenly interested in it.

Here’s how to calculate your net income:

Total revenue – Total expenses = Net income

What exactly belongs in the “total expenses” bucket? Common things like payroll, administrative costs, legal fees, office expenses, licensing fees, and marketing costs.

When your net income is positive, you’ve achieved something special by bringing in more money than you spent to keep your operation running. A negative result often reveals that you have some work to do in order to become profitable, though there will be months when nearly all small businesses come out negative. This is because when you invest heavily in your business, such as buying equipment or upgrading facilities, it will inevitably eclipse the money you have coming in.

Profit Margin

This percentage is crucial because it reveals how profitable your business is. When the percentage is high, you have a recipe for success that’s working. Lower percentages reveal room for improvement.

“As an example of a profit margin calculation, suppose firm A made a profit of $10 on the sale of a $100 television set,” explains a profit analysis from Inc. “Dividing the dollar amount of earnings by the product cost, that firm’s profit margin would be .10 or 10%, meaning that each dollar of sales generated an average of 10 cents of profit. Thus, the profit margin is very important as a measure of the competitive success of a business because it captures the firm’s unit costs. A low-cost producer in an industry would generally have a higher profit margin. Since firms tend to sell the same product at roughly the same price (adjusted for quality differences), lower costs would be reflected in a higher profit margin.”

There are 2 versions of profit margin you’ll usually want to focus on. First up is gross profit margin, which measures how well your pricing strategies are working.

Here’s the formula:

Net Sales / (Net Sales – Cost of Goods Sold) = Gross Profit Margin

Next up is net profit margin. This calculation shines a spotlight on how much revenue remains once all your expenses have been taken out.

Here’s the formula:

(Net Income / Net Sales) x 100  = Net Profit Margin

Profit margins vary substantially from one industry to the next. So if your business is in a traditionally high-margin industry, such as accounting or legal services, don’t snub your nose at a car dealership or hotel with a lower profit margin. Those businesses could be quite successful in the grand scheme of things, but they operate with different margins, given the structure of their respective industries.

What matters is that you know the benchmarks for your industry and then use those profit margins to gauge the health of your business. Check back on these percentages often, as they provide a quick snapshot of your finances and can alert you to larger issues.

Quick Ratio

Let’s make this quick. If you want to know how your cash flow is holding up, crank out this little metric. Quick ratio helps you understand whether or not you have the resources necessary to handle your financial obligations.

Use this handy formula:

(Cash + Accounts receivable + Marketable securities) ÷ Current liabilities = Quick ratio

If your quick ratio is 1, you theoretically have just enough money to cover your expenses. It’s obviously better to have a number higher than 1, which indicates that you have ample resources and assets on hand to make your necessary payments.

Debt Ratio

Borrowing money can be an effective strategy for small businesses. You just need to make sure your debt usage stays at a level you can handle. Debt ratio provides a simple analysis of how well positioned you are to make your associated payments.

Try this formula:

Total debt ÷ Total assets = Debt ratio

If you’re the type of kid who always wanted to have the highest scores in elementary school, you’re going to need to shift your paradigm here. A high debt ratio actually indicates that you are at risk of not being able to meet your obligations.

When you have a low debt ratio, you’ll be better able to manage your debt and should also be able to seek additional loans if you desire. Lenders will consider you a favorable borrower if your debt ratio suggests that you’ll be able to handle the required payments.

Conversion Rate

Prospects are great, but they really only move the needle for your business if they become customers. By tracking your conversion rate, you can evaluate how well your marketing, promotions, and sales are working. When the rate trends upward, you have likely employed a strategy that is helping compel people to make purchases. Identifying these successes enables you to continue bringing in new customers and also building loyalty among those already in your base.

Use this formula:

Conversions from specific period of time ÷ Total number of visitors to website/landing page x 100 = Conversion rate

As your business evolves and customer tastes change, you should continue to go back to this metric. Effective conversions require ongoing improvements.

Customer Acquisition Cost

Let’s suppose that your conversion rate is high and your business is doing a great job of bringing new customers into the fold. It’s crucial that you know how much your efforts are costing.

Use this formula to put a price tag on your customer conversions:

(Total sales + Marketing expenses) ÷ Number of new customers = Customer acquisition cost

When your customer acquisition is costly, you’re negating the benefits associated with bringing in each customer. It would be like if your friend boastfully showed you a beautiful diamond that she intended to have set in a custom ring. Your friend tells you that the diamond only cost her $5 because she had bought it as coal then converted it to a diamond using the machinery she’d installed in her basement. You might initially feel envious because the much smaller diamonds in your jewelry had cost thousands of dollars. But then you ask your friend about her diamond-producing machine and she reveals that it cost $387,000 to install. Suddenly, the $5 she spent on coal is exposed as a farce. She’s spending much more to convert her bargain-priced coal into diamonds.

Customer Retention Rate

Regardless of how much you’re spending on customer acquisition, you can’t afford to let them leave. Retaining a customer will always be less expensive and time-intensive than attracting a new one.

Use this formula to see how well you’re hanging on to your customers:

(Total customers at end of time period – New customers during time period) ÷ Customers at start of period x 100 = Customer retention rate

Using this metric allows you to gauge the impact of your various initiatives. You’ll be able to invest in the best ways to keep your customers loyal. 

Making Your Business More Formulaic

Hopefully, reading about these formulas helped remove a little of the mystique surrounding them. You definitely don’t need to be Will Hunting to crunch these numbers. You probably just need a calculator and a few minutes of time.

As a wise entrepreneur once said, “Keep your friends close and your formulas closer.” By consistently checking in on your crucial business metrics, you’ll be able to keep doing what’s working, stop doing what’s not working, and identify future ways to get even more things working. And, come on, who wouldn’t want that?