Measuring short term liquidity

The short-term liquidity or cash position of a company play a significant role in determining its financial health. Short-term liquidity, also known as working capital, is critical for day-to -day operations. It’s determined by the nature and size of business, seasonal variation in sales, change in input or raw material prices and length of the production cycle.

Analysts use different ratios for analyzing the effectiveness of the working capital management and one of such ratio is the cash conversion cycle (CCC).

CCC measures the lifecycle of cash and estimates the number of days in which a company can convert its resources into cash. It is derived using three sub-ratios—days inventory outstanding (DIO), day sales outstanding (DSO) and days payables outstanding (DPO). All three sub-ratios are also expressed in the number of days.

DIO measures the days in which a firm converts its inventory or raw materials into sales. DSO determines the number of days in which a company collects money from its customers for the sales made on credit. Often a company also purchases raw materials or inventory on credit which creates payables outstanding. DPO measures the number of days in which the company is required to pay its suppliers for purchases made on credit. CCC is calculated by subtracting DPO from the sum of DIO and DSO.

Lower the CCC, the better it is, as it implies that the company’s resources are locked into inventory for a lesser number of days. Consequently, it is less dependent on borrowed money for running day-today business operations. The lower ratio is also indicative of strong cash flows and improved liquidity. On the other hand, high CCC levels over a period of time requires investigation as it implies a slower inventory to sales conversion process.

Important metrics to use for PMF

Q. What is PMF?

A. Product market fit, when you hit the right fit with the market or when consumers accept your product, it’s basically getting consumer love. It essentially says your product has a market. Studying customer obsession, delight, satisfaction is important, but first you should know if the product has a market that means it has customers.

10 delighted people is better than a 100 happy people, especially in the early stages. At a seed stage startup, if I am the entrepreneur, I want to measure one thing: are people happy or delighted. Not satisfied.

Important to see the net promoter score (NPS) and then see the customer satisfaction score (CSAT). One is about virality and the other is about satisfaction. And it gets you repeat business. So basically what one should focus on is if people are happy with the product and therefore the product will get word of mouth.

Different businesses, for example even B2B businesses, SaaS businesses, every business by definition has customers. There is no difference - there may be nuances on how one measures in each case, but here is no difference in NPS and CSAT. It is what it is. Are my customers happy or delighted?

After that when I have reached that where I feel, okay, I have a set of people and I am going to get word of mouth, tongue in cheek I am going to say now, are people going to put their money where their mouth is. You can give things away for free and people will be delighted. The next phase which is post the series A phase give or take is with this objective: are people going to put their money where there is mouth is?

Now how to measure that? There are multiple ways. So, one of the core metrics which we have discussed before also is cohorts. But cohorts at this stage one needs to look beyond just usage cohorts and also look at spending cohorts. If I have really hit delight with some customers, not only should they be buying repeatedly with me but hopefully over a period of time they are buying more and more. In the first month, they may buy once. Second month, they will buy twice. And they are spending more and more money. That is one of the earliest foundations.

A negative revenue churn is when the company does nothing, their existing customers keep spending more and more, and the business keeps growing. So these metrics are not just for consumer businesses, they apply everywhere. And I would call the second phase more of spending cohorts.

Third phase is if there is a business model with which the company can make money doing that? And in the third phase you start looking at unit economics, how much does it cost you to acquire a customer, how much is their lifetime value.

At the second phase, we would think about some level of margin even though when we were looking at spending, we would have said what is the gross margin of the product? What is the basic cost? If you are selling below your cost, it’s a problem.

At the third stage, since you have to look at it more as a business, you have to start looking at contribution margin. And if all these things start firing, you will see it becomes a profitable, scalable business. I think that’s really the core of how one should think about it at different phases.



Q. As a founder, it’s always easier to spread yourself wide and try tracking all that you think is relevant for your business. But, should you set a limit? And then, prioritize the number of metrics to track? And within this are there specific metrics that are indicators of your company’s health like indicators for performance, growth, product improvisation something on these lines?

A. If used incorrectly this science can hurt you as much as it can help you. Example, on an ecommerce site’s last page after the payment, it asked a NPS question: “How likely are you to recommend this to others?” I have not received my product yet. So, what are they measuring? That’s A. B That is not the place to ask NPS. That’s the place to ask a CSAT question to say how was your website experience. It’s an ecommerce site. I haven’t received my product.

By the way, it doesn’t let me ignore that question. So now whatever I clicked and submitted is noise not signal. And people may be taking actions on that. So, it extremely critical to understand which metric is relevant where. On prioritization of these metrics give or take maybe five metrics or six metrics that can define any company: NPS, CSAT, gross margin, contribution margin, and finally the EBITDA. Now there is return on capital.

Less is more. Think carefully about if I could measure only one thing it may be too little, but two or three things that are most important. That’s number one. Number two, how and where you measure, it’s almost more important than what you measure because you may end up otherwise making wrong decisions.

Number three, people can tend to get buried - again to your question on measuring too many things, measuring them at various deep stages. Thinking of it top down to say what is the architecture of my business. If I am an ecommerce site, this is the architecture. If I am a SaaS site, this is the architecture of my business. And in each piece of that architecture at the top line level, at the midline level, at the bottom line level, can I pick one or two metrics? And, at the operating metrics level which gave me a sense of the health of the business.

Finally, very important, I think most companies that measure statistics themselves likely err on the side of being more positive than the reality. And so, I am a big believer and I often advised founders that always have third parties. Do outside in surveys, mystery shopping, and even NPS scores. For example, I have seen gaps of 20 points between what a company reports and then if a third-party diligence is done or a third-party survey is carried out on what is reported.

Where you are measuring, who you are measuring with. If you are measuring with your own customers, how do you know who has lapsed out because they weren’t happy and how are you measuring, then the real satisfaction which is why companies own surveys tend to be always overstated because the people who are really unhappy and who went away are no longer in the measurements by definition. So that’s critical.

Like I said, the best thing to do measure fewer things, make sure you are measuring them at the right place and at the right time. And third, triangulate with a lot outside in data.