In the world of business, unlocking true potential is akin to finding the perfect combination to a complex lock. Greg Crabtree, a preeminent voice in financial consulting and author of “Simple Numbers, Straight Talk, Big Profits!” and its sequel, offers a master key in the form of “The Four Simple Numbers.” These strategies, distilled from his extensive experience and insights, are not just theoretical concepts but practical tools designed to propel entrepreneurs and business leaders toward heightened profitability and financial mastery.
Each cornerstone—Return on Invested Capital, Total Labor Efficiency Ratio, Profit to Gross Margin and Core Capital Target —serves as a crucial pillar in building a robust financial foundation for any business. As we delve into these transformative principles, we invite you to explore how these key simple numbers can unlock the latent potential within your own venture, setting the stage for sustained growth, efficiency, and stability. Whether you’re at the helm of a fledgling startup or steering a mid-sized enterprise, the journey towards financial clarity and success begins with turning these keys in your business strategy. Let’s step into the world of Greg Crabtree’s “Four Cornerstones of Simple Numbers” and turn the gears of change for your business’s future.
Understanding why Return on Invested Capital Matters
"A privately held business is likely the highest rate of return asset year over year that you will ever own."
Return on invested capital is arguably the most valuable seest in your wealth profile.
Think of owning a bond or a certificate of deposit. You put $100,000 into a deposit at 5% interest. A year later, the bank gives you your $100,000 back with $5,000 of interest. They ask “would you like to do it again?” You answer yes and give them $105,000 and go another year.
Businesses work the same way except you may not get your original investment back whenever you want it without selling the business. But a properly run business can distribute its earnings once it stabilizes.
What is Return on Invested Capital (ROIC)?
Let’s start with invested capital. Invested capital is money you put into your business. This includes sweat equity which is the role an owner plays at less than market wage. Debt is not included in invested capital.
Your pre-tax business profit divided by your investment in the business is your return on invested capital. The shocking data point to most entrepreneurs is that your minimum target for ROIC is 50%! If you are in a light capital requirement business it can be between 75% and 150%. Not too many investments can yield that on an annual basis.
Each year that you leave some of your profits in the business to aid in growth, that adds to your invested amount. It works just like rolling over your CD interest to the next year. There is an eventual point that the business has all of the cash it needs to grow and leaving more in will not yield the 50%+ return. That is when you need to take the excess out and diversify your investments.
Sample Business Case
Setting the Right Profit Target for Sustained Growth
"Sales are for show, profits are for dough!"
Profit isn’t just a number indicating success; it’s the lifeblood of sustainable growth in any business. Defined as the financial surplus after all expenses have been paid, profit conveys the efficiency and viability of a company’s operations. It serves as a key indicator of health and a critical measure against which business success is gauged.
For business owners, setting profit targets is an essential exercise in strategic planning. Establishing clear targets enables them to track performance and make informed decisions about investments, cost management, and growth strategies. By deemphasizing revenue and focusing our research on profit to Gross Margin, we have been able to estable a near universal standard for all businesses in setting profit targets. For Simple Numbers businesses:
- Minimum profit to Gross Margin should be 15%
- Target should be 20%
- Stretch is 25%
Any businesses operating above 25% will find it challenging to scale, but if you can and maintain that profit rate, go for it!
Pretax Profits
While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a common metric used to assess a business’s operating performance, it often overlooks critical financial burdens like interest, depreciation, and amortization. For small business owners, it is more prudent to focus on pretax profit, which provides a clearer picture of financial health by considering all operating expenses except taxes. By honing in on pretax profit, owners can gain a more accurate understanding of their true profitability, making it easier to identify areas for improvement and make.
Total Labor Efficiency Ratio is the Key Metric to Manage Labor Productivity
"The teams that win are the teams that get the most productivity for every dollar of labor."
Labor productivity is a critical aspect of cost management within any business. When businesses are below the $1 million revenue mark it’s easy to keep an eye on labor productivity. Afterall, nothing of value happens without a productive workforce. However, as businesses expand and grow, it becomes harder for them to manage labor productivity.
Why “2” May be the Most Important Number in Your Business
Business owners have been looking at labor productivity wrong for years! When Greg Crabtree started studying small business data sets across a wide range of industries, a simple number emerged: companies that hit the Simple Numbers profit target of 15% to 20% of Gross Margin had $2 of Gross Margin for every dollar of TOTAL wages paid. This number is known as the Labor Efficiency Ratio which is the gross margin divided by all labor. CEO to floor sweeper, they all count!
This metric had been hiding in plain sight for decades. Labor dollars measured against some form of margin is a more correct analysis than measuring bodies per revenue. Regardless of inflation, price changes, material cost increases, application of technology enhancements, profitable businesses always reverted back to a Total Labor Efficiency Ratio (LER) of $2.
Yes, there are a handful of outliers, but not many. Retail and distributors generally need to be around $2.50, but outside of those, the list drops off quickly. Greg Crabtree’s general guidance is having businesses target between $1.90 to $2.10 for their LER.
Once you know what your LER is, you have two choices, grow into the labor you have or cut to get profitable with the revenue you have. It is one of our most critical health diagnostic tools we use to help fix a broken business or help take an ordinary business to the next level.
Core Capital Target - Cash Commitment to being a Fully Capitalized Business
"Cash is the most powerful opportunity magnet ever created.
One of the most common questions Greg Crabtree receives is “How much cash should I keep in my business?”. Every advisor from CPA’s, to bankers to investments advisors would have a different number that was biased to their goal, not the business’ need.
While writing “Simple Numbers, Straight Talk, Big Profits”, Greg Crabtree looked at 50 company data sets and asked the question “What is the deepest negative cash flow a business experiences in the last 3 years?”. From that question, he concluded that no one in the data set of ongoing businesses had a month where they used more than 2 months of operating expenses plus payroll. Essentially, all costs that you do not get terms for. Lines of credit are not inherently bad, but they are meant to be temporary and sloppy entrepreneurs have overused them instead of building cash before taking profit distributions.
This is the concept of “Core Capital Target” used by Greg Crabtree since 2007. Core capital target forces you to pay for accounts receivable, inventory and equipment with cash or term debt. There are very few exceptions where a business needs more than 2 months of operating expenses plus payroll during a downstroke. And while you may not be able to prevent the downstrokes from happening you can make sure you have the cash to cover it.
Greg notes “What is odd is that I used to have to beg my clients to leave cash in the business, now I have to prod them to distribute the excess cash that is idle”. His clients who follow this cash guideline significantly lowered their stress and increased profitability because the cash buffer allowed them to be patient during market disruptions and take advantage of opportunities that cash strapped businesses could not.
Applying "The Four Simple Numbers" to Various Business Models
What makes “The Four Simple Numbers” especially powerful is its universal applicability to businesses of all shapes and sizes. Each key plays a critical role regardless of the business model, industry niche or geographical location.
ALL businesses have labor. By focusing on Gross Margin instead of Revenue, it normalizes the P&L analysis. By also focusing on Return on Invested Capital, it makes you pay attention to the Balance Sheet (that sheet that entrepreneurs like to not look at!) and find ways to get paid faster and get vendors to work in partnership with you to have margin flow fairly through each transaction for everybody’s benefit.
Book Greg Crabtree
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Common Mistakes to Avoid When Implementing "The Four Simple Numbers"
Implementing “The Four Simple Numbers” requires a holistic approach, and overlooking any one of them can lead to significant financial challenges and missed opportunities.
Overlooking the importance of any single Simple Number can jeopardize the overall financial health of a business. For instance, neglecting return on invested capital may lead to stagnant growth and inefficient capital allocation.. Similarly, missing core capital targets can create unnecessary stress and make it more difficult for businesses to weather market disruptions.
Business owners often forget to adjust their strategies as their companies grow. An owner’s salary that was once appropriate for a startup may no longer be suitable for a mature business. Moreover, businesses must measure their labor productivity ratio to ensure profitability and scalable growth. By avoiding these common pitfalls, entrepreneurs can better implement “The Four Keys” and steer their businesses towards long-term success.
How to Start Implementing "The Four Simple Numbers" in Your Business Today
Implementing “The Four Simple Numbers” in your business might sound daunting, but the good news is that it’s never too late to start. While each key has its unique considerations when applying them collectively offers a powerful financial management framework.
- Return on Invested Capital (ROIC)– Begin by calculating your current ROIC by dividing your pre-tax business profit by your invested capital (excluding debt). Aim for a minimum ROIC of 50%. Regularly review this metric to ensure that your profits are being utilized effectively, and reinvest in areas of the business that can yield higher returns. If you find this process overwhelming, consider hiring a financial advisor or consultant to help you analyze your investments and refine your approach.
- Gross Margin Target– Establish clear targets for your gross margin, aiming for a minimum of 15%, with a target of 20% and a stretch goal of 25%. Analyze your pricing strategies and cost structures to ensure profitability. Continuously monitor your actual gross margin against these targets and adjust your strategies accordingly. Engaging with a financial expert can provide insights into industry standards and effective pricing strategies, aiding you in achieving your margin goals.
- Labor Efficiency Ratio (LER)– Calculate your Labor Efficiency Ratio by dividing your gross margin by all labor costs, ensuring you hit the benchmark of $2 of gross margin for every dollar spent on labor. Use this metric to assess productivity and make informed hiring or downsizing decisions. Regularly review your labor costs in relation to your gross margins to identify inefficiencies. Bringing in an experienced operations consultant can greatly enhance your ability to optimize workforce performance and improve overall efficiency.
- Core Capital Target– Determine your core capital target by maintaining two months’ worth of operating expenses in cash reserves. This buffer protects your business from financial strain during downturns and allows you to capitalize on opportunities when market conditions are favorable. Regularly assess your cash flow and adjust your capital reserves as needed. A financial advisor can guide you in establishing a strong cash management system, helping ensure your business remains fully capitalized for optimal growth.
By integrating these metrics into your business strategy, you can lay the groundwork for sustainable profitability and informed decision-making. Seeking professional assistance may help simplify the process and provide valuable insights tailored to your specific industry and circumstances, setting your business up for long-term success.
Ready to Open the Door to Simple Numbers Success?
As we’ve explored the critical strategies encapsulated in “The Four Simple Numbers,” it’s evident that the path to unlocking your business’s full potential is through deliberate and informed financial management. By understanding and applying these principles, you are setting the stage for sustainable growth, efficiency, and stability. Whether you’re at the helm of a start-up or steering an established enterprise, these keys can help you navigate the complexities of business finance with confidence.
If you’re ready to take the next step and translate these insights into actionable success, reach out to explore Greg Crabtree’s speaking engagement or consulting services. Crabtree’s expertise in simplifying business finance is at your disposal to help tailor these strategies specifically to your unique situation.
In a collaborative approach with Greg Crabtree, you can work to optimize your ROIC, focus on gross margin, maximize labor efficiency and reach your core capital target.
Don’t let the potential of your business remain just a possibility. Implement “The Four Simple Numbers today, and watch as the doors to financial clarity and success swing wide open.
