If you combine this ratio together LTGP to CAC if your ratio isn't at least three to one, that could be a sign of trouble as it relates to sales efficiency. This podcast, boosting your Financial IQ, is about business financial literacy, strategies for profitability and the principles taught at byfiqcom. My hope is that you'll apply the lessons learned and that we can work together soon in my mastery program. Enjoy the show and don't forget to subscribe. As a business owner, there are so many things to pay attention to. Today, I'm going to give you three things that every business should be measuring in order to understand their true economic performance and where to identify issues in the system From the top level. When I think of an entrepreneur, I think of somebody who's spinning plates. So they have a bunch of plates spinning in their hand. They have payroll spinning over here, customer satisfaction over here, product and quality over here, and they're trying to spin all these plates and keep everything in the air and from falling. And that could be quite a task, especially for entrepreneurs and business owners who are trying to juggle a lot of different things and a lot of different business units. I've been there before, so what I like to do when I'm looking at growing or just optimizing a business is. I like to focus on three different efficiencies First, sales efficiency. Second, operational efficiency and then third, value creation efficiency, or just value efficiency. I'm going to explain how I measure each of these three efficiencies here in this episode. So get ready, grab a piece of paper or get ready to take some notes, because these three measures will be super critical for your business. Now, with each of these efficiencies, I like to explain things as a flywheel. So think of each of these efficiencies as a flywheel, like a bicycle. You know the big gear on a bicycle, then you have the little gear in the back. The same thing is true with these efficiencies. They're like gears and like a bicycle. Sometimes it takes a little bit of effort to get the bike moving. To get that forward momentum, you start pedaling, you really have to push down, but once you get the wheel spinning, the pedal goes around faster and faster and that's the flywheel. That's the whole idea of a flywheel is, once you get it going, then it spins faster and faster and that's how you're able to scale. So the same thing is true with these efficiencies, if you can measure them from the very top level in these measures I'm going to give you in just a minute. Then you'll know exactly where things are breaking down in your business Either it's sales efficiency, operational efficiency or value creation efficiency and you'll know how to fix them. All right, so let's get into the measures.

With sales efficiency, I like to measure this through LTGP to CAC. Ltgp stands for lifetime gross profit. Another common term for this is LTV, which stands for lifetime value of a customer. But I like LTGP better because it gets more specific. It's basically the same thing. I just think people out there misunderstand what LTV is and they will confuse lifetime value of a customer with the revenue of a customer. Well, revenue is not the lifetime value. You have to look at gross profit, which is revenue minus your cost of a customer. Well, revenue is not the lifetime value. You have to look at gross profit, which is revenue minus your cost of goods sold. All right, so LTGP lifetime gross profit and then CAC is your customer acquisition cost, the cost of acquiring a new customer in your business. So if you combine this ratio together LTGP to CAC and if you have at least a three to one ratio, you're in good hands. A lot of the high performing companies that I work with. They have a ratio of 10 to one or greater, which is really good, because over time, ltgp this ratio compresses Because think about it as you continue to scale your business, it's going to be harder to find new customers. You start cannibalizing customers in the marketplace and therefore this number gets smaller, it shrinks. So the bigger the gap, the better, and if your ratio isn't at least three to one, that could be a sign of trouble as it relates to sales efficiency. All right, so, like I said, to find LTGP you're gonna go to your income statement, take revenue minus cost of goods sold that will give you gross profit and then divide that number by the number of purchasing customers in that period and then you'll figure out the gross profit per customer.

Now for the lifetime of the customer the LT part of the acronym. You can either do what I do. If I don't know the true lifetime of a customer, you can just take one year. That's the most conservative way to look at LTGP. Is you just say, okay, I'm going to look at the lifetime gross profit as one year, the gross profit, in other words, for a customer for a 12 month period. Right, that's most conservative. Now for other businesses, what you could do is you could look at your churn rate. That's the number of customers you lose in a given period. And let's say your churn rate is 10%, that means every 10 years you'll lose all your customers. So you can do the reverse math and figure out the lifetime of your customers, all right. So there are a lot of ways to get there. Like I said, if you want a baseline that's super conservative, just take one year or some variation thereof. Conservative, just take one year or some variation thereof, all right. So that's the first measure, which is LTGP.

Now let's talk about operational efficiency. When it comes to operational efficiency, I like to measure this by computing return on labor. So to find this number, you could do a couple things with your labor. First, you could take total labor for all your employees, both cost of goods sold employees and operating expense employees or employees that are classified in those two areas. You could take the total labor cost of, in other words, of your entire company and then divide that by your net operating profit after tax, and that will give you your return on labor. Now there's some variations. Maybe you just want to measure the return on your production labor, so you may take your production labor costs and divide it by your NOPAT your net operating profit after tax. Or you may want to do some other combination with labor. Whatever it is, that's the math. It's just labor divided by your profit, and I like to use net operating profit after tax.

Now you may be wondering okay, how do I treat net operating profit after tax, especially if you're an LLC or you're an S corp? Because those entities in the United States are passed through entities, meaning that those entities themselves don't pay corporate income taxes. Instead, the profits flow through on a K one to the owners of the company, the shareholders, and they end up paying the taxes. But when it comes to looking at the operating profit in a business, I like to look at it net of taxes. So in order to compute that, there's a few ways, and I'll just give you the quick and dirty way. You can A go to your tax return, like if you're the sole shareholder, look at your tax return and see what the effective tax rate is that you paid on your business's income. That's one way. The other way is just to use some average number between, I'd say, 30 and 35%. If you want to be a little bit more conservative go 35%, and this will cover you for the intent and purpose of computing net operating profit after tax.

Essentially, what you want to do is when you're looking at your numbers in your business. You don't want to just be looking at operating profit before taxes, because you may be tricking yourself. Ultimately, somebody has to pay taxes, so you have to account for that, all right, so that's how I like to compute net operating profit after tax, even for businesses that are passed through entities. Oftentimes, I'll just use an effective tax rate of 35% and then, therefore, I'll take my operating profit before taxes and multiply it by one minus the tax rate, and then that will give me a pretty good rule of thumb for net operating profit after tax. And, like I said, I have to estimate the effective tax rate because, think about it, some businesses have multiple owners and each of those owners have a different tax rate, and therefore, don't make it brain damage, just use some type of number and that'll be good enough. All right, so that's how you measure operational efficiency.

Return on labor. Now let's move on to the last flywheel, which is value efficiency. This is how you're going to measure whether your business is creating or destroying value, the metric that you're going to use is return on invested capital. The calculation is NOPAT, so it goes back to that net operating profit after tax that we used with return on labor and you're going to take that NOPAT divided by your invested capital. Now invested capital has two parts. First, it has working capital.

You can compute your working capital by going to your balance sheet, taking your current assets minus excess cash. So if you're sitting on a ton of cash beyond what you need for a normal, compute your working capital by going to your balance sheet, taking your current assets minus excess cash. So if you're sitting on a ton of cash beyond what you need for normal operations, you're going to want to exclude that and then take your current assets less this excess cash and subtract out your current liabilities and make sure you exclude any interest bearing current liabilities. So, for example, you may have the current portion of long term debt that's doing payable within 12 months. Maybe that's in your current liabilities. Or maybe you're using a line of credit and you're paying interest on it and it's revolving. You're going to want to exclude that from the calculation. So working capital in summary is your current assets less excess cash, minus your current liabilities, excluding interest bearing liabilities. All right, that's your working capital.

The other part of invested capital is your net PP&E, which PP&E stands for property, plant and equipment. I say net because you want to take your gross PP&E on your balance sheet and then subtract your accumulated depreciation. All right, I'm just summarizing. There's some nuances in the calculation, but I think this will get you there if you just follow this general formula. So, like I said, return on invested capital is your NOPAT divided by your invested capital, and this will tell you what your business is earning in regards to returns on your invested capital. The reason why this is important is because, let's say, you do the math and your return on invested capital is 5%. Well, think about it In the stock market in the United States over the last 50 years, the average returns is like 9% to 10%. So if you're only earning like 5% or 6%, then you're earning below average returns of what you could just earn by going and buying Apple stock or Google stock and avoiding all the headache of running your own business.

Now I'm being dramatic here. I'm not saying go sell your business and put all your money in Apple or Google or whatever. I'm just saying that you have to ensure that the juice is worth the squeeze, because, as you know, as an entrepreneur or business owner, like running a business is tough, right. So you want to return on invested capital that at least exceeds what you can earn out there in the market. And the second part is your return on invested capital has to exceed your cost of capital, otherwise you're destroying value. So if you're blended cost of debt and equity, which is known as your weighted average cost of capital I've done other episodes on this, I have a video on my YouTube channel where you can check that out too but if your weighted average cost of capital is 12% and your return on invested capital is 10%, you're destroying value because you're taking money at a cost of 12% and you're only earning 10%, so therefore you're destroying 2% of value. So therefore you know your company is creating value when your return on invested capital is greater than your cost of capital. And the cost of capital varies from business to business. I've seen some companies with a 10% weighted average cost of capital and other companies with a weighted average cost of capital of 15% or greater. So it varies by business.

The key thing is is to start measuring your return on invested capital. So there you go, the three measures for the three efficiencies LTGP to CAC. That's for sales efficiency, your return on labor, for operational efficiency and your return on invested capital for your value efficiency. And if you start measuring these in your business, you'll know which flywheels may be stuck and where you need to focus in order to drive greater value overall in your business, to improve your operational and financial performance. All right, that's what I have for you today A lot of nerd talk, a lot of formulas. Hopefully you found that valuable, and if you ever need help with any of this, feel free to reach out at coltivarcom. We're happy to help your business put in place the right type of metrics so you could blend strategy and finance together to create tremendous value. All right, until next episode, take care of yourself. Cheers.