Alex Douzet is CEO of Pumpkina pet insurance and welfare provider founded to ensure pets live their healthiest lives.
Financial literacy is an essential skill that can strengthen you in the workplace. Even if your role isn’t directly related to your company’s financial activities, understanding it can help you identify key metrics for your company’s success. Data doesn’t lie, and these stats can tell you if your business is on track to become profitable. They also help contextualize how your individual contributions support the company’s long-term financial goals.
With that in mind, here are five key financial concepts every employee should understand and be able to discuss with confidence.
1. Turnover and Gross Margin
To distinguish between these, let’s take the example of a grocery store. Sales is the total dollar amount of all products the store sells. You calculate gross margin by taking that number and subtracting any direct costs the company pays to be able to sell those goods, such as the packaging of products and the labor to store them. These are called COGS or cost of goods sold.
Gross margin is expressed as a percentage and shows how much of every dollar of sales a company keeps as profit. So a gross margin of 60% means that a company keeps $0.60 of every dollar sold. Target profit margin is industry specific, so research what is normal for your industry. Keep in mind that a low margin doesn’t necessarily mean a company isn’t profitable.
2. Variable and fixed costs
Every business has to spend money in order to function, and that includes two types of costs: variable and fixed. Let’s return to our supermarket example. The variable costs are costs that change depending on how much a company sells. For example, in a supermarket, variable costs include the actual products such as meat and vegetables, which fluctuate with market demand. The fixed costs are expenses that do not change regardless of how much the store sells, such as the rent of the building. When a company fully understands its variable and fixed costs, it can set a price for its products that allows it to be profitable and account for cost fluctuations.
3. Unit of Economy
Unit economics makes it easier to see how fixed costs directly affect the profit made from one unit of your company’s goods or services. Take the sale of a TV that sells for $500. The TV company has fixed costs for the materials to make it, for shipping to the customer, and for credit card transaction fees that total $150 or more. This means they make $350 for every TV they sell. Looking at these unit spends can reveal areas where efficiency and profit can be maximized, such as reducing fixed shipping costs by using a different provider.
When determining whether a business is profitable, ask yourself, “‘How much profit are you making?” probably won’t give you the right answer. Instead, ask specific questions that help you get an accurate picture of a company’s financial health. Inquiring about EBITDA is one way to do that. EBITDA stands for “earnings before interest, taxes, depreciation and amortization”. It can be thought of as a company’s cash profit and can help you judge the profitability of one company against another.
It’s common to see a negative EBITDA number for a startup company, and that doesn’t mean the company isn’t profitable. It may mean that the company is in an investment phase of its life. Tech startups, for example, tend to invest heavily early on and tolerate losses before generating profits. Asking about the multi-year timeline can help you understand EBITDA over the life of your business. Instead of pursuing aggressive growth in a short period of time, it may be that year five of the company is when they predict EBITDA will show positive reading.
5. LTV:CAC ratio
The LTV to CAC ratio helps you understand how efficient your company is at acquiring new customers. Let’s start with customer lifetime value (LTV or CLTV). Imagine you have a store that sells snow boots. Your retention rate is how long customers have been buying from your store, which we think is an average of 20 years. In those 20 years, customer Jane buys boots from you four times. That means Jane generates $800 in income for you over those 20 years. If the gross margin on your snow boots is 60%, Jane’s customer lifetime value is $800 x 60%, which equals $480.
CAC is customer acquisition cost, or how much you spend to get a customer to buy from you. At first, Jane didn’t know about your store. The CAC is all the money you spent to get Jane as a client. Imagine you spent $160 through social media and TV ads to acquire Jane, so $160 is the CAC.
Since you spent $160 to get a $480 LTV, your LTV:CAC ratio is 3:1, meaning you earned $3 for every $1 you spent getting Jane as a client . A ratio of 3:1 is the target zone and what you should be looking for in your business. If the ratio is 1:1 or 2:1, the company is spending too much money to acquire one customer. Businesses can grow quickly in terms of customers, but if they spend $0.99 cents to get $1 back, that’s not a good thing. On the other hand, a ratio of 4:1 or higher is too efficient. A high ratio means the company is not spending enough to get all the customers interested in the product or service.
As a startup founder, I’ve found that increasing equity in financial literacy helps a company thrive by fostering trust. It’s a good sign if management is open about corporate finances, but you’ll only benefit if you can interpret the data you’re given. If your company doesn’t currently offer help and education, take advantage of the free online resources available to help you master these concepts. By equipping yourself with a solid foundation in business finance, you can increase your chances of upward mobility.