Like most owners of marketing agencies, you’re the one who feels the most responsible for tracking your business’s performance and profitability. Maybe you even hired a bookkeeper and a tax accountant to tag team the job. But do they know what to look for?
Rarely, as it turns out. You may assume that the professionals you hire are asking the right questions, but accounting in agencies or professional service firms requires a more niche skill set. In fact, many bookkeepers and accountants will measure business profitability by looking solely at sales, or gross revenue — it’s an easy number to find, and most industries use it as their number one KPI.
In reality, there are so many more financial markers that can accurately measure how a business is performing. With agencies and professional services, in particular, it’s critical. If you’re not tracking the right KPIs, you’re likely to miss something major about your agency’s operations that could be hurting your profitability.
We are going to dig into how, starting with a cautionary tale of what happens when you track the wrong financial KPIs. Specifically, in this article we will cover these must monitor metrics:
By the end, your confidence in how to better measure your business performance will be up, and the intimidation factor of how to use these terms will be way down (we’re looking at you, EBITDA).
The Dangers of Tracking the Wrong Financial KPIs
Picture this: an agency looks at sales to measure its performance, and they think they’re a 12-million-dollar business. They go on a hiring spree and increase their staff from 25 to 60 employees. They invest in a new (more expensive) space. A few months later, they’re cash poor. How did this happen?
Here’s where they went wrong: in measuring their performance, they only looked at one number — the top line. When they looked at their top line (i.e., gross revenue), they neglected to note that much of this number doesn’t belong to them. If you were previously a strategy agency, and you just picked up a new client who brings a lot of media buying with them, your top-line revenue is going to grow really quickly, but your net revenue isn’t going to change very much. Complicating this further is the fact that most media is billed and paid before running the media. Therefore, not only is your top line growing rapidly, you suddenly find your agency with a lot of cash in the bank.
So yeah, that “12-million-dollar business?” They’re more like a 4-million dollar business. If they invested in growth like they were a 12-million-dollar business, it’s not until the $8 million in media costs show up later that they will realize their error.
Their only option to keep themselves from sinking is to cut salary and overhead costs. A business might be able to absorb one or two layoffs and the consequent termination fees. But it’s not easy to remove that many people as quickly as may be necessary. Beyond that, even if the business somehow survived bankruptcy, it would be near impossible to produce the same results for clients as you had with 60 employees. In short, their strong gross revenue results and healthy cash balance allowed them to overservice their clients without feeling the pain — until they did.
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You don’t want to make the same mistake. Make sure you’re tracking the financials that actually matter. Here are the 6 KPIs that are critical to understanding your business’s performance.
6 Financial KPIs Your Firm Should Be Tracking
1. Net Revenue (also referred to as Gross Profit or AGI)
This cannot be overstated. Net revenue is critical because it finances everything in your business, including employee training, rent, insurance, and office supplies (and don’t forget it can finance an accountant who knows the right KPIs to look for, too!). Moreover, it’s the basis on which all other important KPIs at a professional service business are measured.
Unlike sales, net revenue is the measure of your total sales over a period of time, minus the cost of the goods sold in that same period. Another way to look at net revenue is that it’s the portion of the total revenue from clients that the agency keeps, whether in fees, or markup on third-party costs.
For example, if you charged a client for printing a brochure, you would charge them your agency fees, the amount it would cost your agency to pay the printer, plus a markup fee on the printing costs. Your estimate might be $4,500 for the printing job, and you decide to mark up the cost by $500. Your fees for the design and production of the job are $5,000. Therefore, the total selling price is $10,000. But it’s $5,500 that you actually keep — AKA the net. If you were only measuring gross revenue numbers, you might invest against your $10,000 in revenue, and that could lead to some unwise spending decisions down the road.
What You Can Learn From Net Revenue
If you benchmark net revenue, you should be able to see a trend in your profitability month over month. Assuming your headcount isn’t changing much on a monthly basis, it’s unlikely that you will see large fluctuations in your net revenue. If you do, you most likely have a revenue recognition issue.
2. Staff Cost Ratio
Staff cost ratio is a quick proxy for profitability potential. A staff cost ratio is the cost of employing all your staff as a percentage of revenue. The formula for this ratio is:
cost of labor ÷ net revenue
In an ideal world, your cost ratio is below 60%. If it’s higher than 60%, you are either paying your team too much compared to what you are charging your client, you have hired too many employees compared to what you are charging your clients, or you have hired too many administrators for the size of your organization.
Realistically, staff costs and rent should be an agency’s biggest expenses. If you manage your staff costs and your overhead expenses well, it’s unlikely your business wouldn’t be profitable if you can keep your staff costs below 60% of your net revenue. With that in mind, a staff cost ratio that’s over 60% isn’t necessarily the end of the world. Since the pandemic, overhead costs have generally decreased as more workers opt to work from home. If you have less to spend on rent, you might decide to invest more in staffing. It’s your call to make but realize if you choose to invest more in your team, you will want to try to offset that with a lower investment in non-salary overhead.
3. Net Revenue per Full-Time Equivalent
To get this number, you divide your total net revenue by the number of employees — both billable and non-billable — employed by your agency. A healthy number should be at least $150,000 per full-time equivalent, but the number usually falls between $150,000 to $200,000. If the number is below $150,000, it’s an indication that your business has a profitability problem.
4. Capacity
Capacity is basically a productivity target, and it’s not hard to calculate. Here’s the formula:
number of hours available x billable rate.
For example, say the billable rate for each of your employees is $175 an hour, and you expect six hours a day of billable work from them for however many days are available in a year (let’s say 260). The calculation of your capacity would then be:
$175 x 6 hours x 260 days = $273,000
In other words, $273,000 is the amount of revenue you should expect from each employee. You can multiply that number by how many employees you have.
Let’s say you do that math and see that your capacity should be $2.5 million in net revenue, but your agency is only generating $1.8 million. What’s happening to that remaining $700,000? The questions you should be asking are:
- Are you servicing clients too much?
- Are you not charging enough for the work you are doing?
- Are there a lot of employees with too much free time on their hands?
- Do you have certain skill sets on your team that are very difficult to maximize?
Very few agencies sell all of their available capacity. But the agencies that do the best job of optimizing their available capacity are the most profitable agencies.
5. Realization
Realization is a percentage of total capacity converted into fees and agency markups. The formula is:
net revenue ÷ available capacity.
For example, let’s start with the capacity calculation. Say you are a 10-person firm and your target blended rate is $150/hour. You calculate your capacity as $2,587,500 annually (37.5 hours/week, 46 weeks a year, $150/hour) or $215k per month.
You then divide your average monthly net revenue by your capacity. Let’s say your net revenue is $160,000. Your realization rate calculation would be:
$160,000 ÷ $215,000 = 74%
This is an excellent realization. Rarely does a firm ever realize all of its available capacity, but a well-performing one realizes at least 60% of it. 74% is not too shabby!
To get the most value out of your realization rate, track it monthly. You will recognize a trend for your firm, and be able to react quickly if the rate shows unusual variation.
6. EBITDA Ratio
It’s a big acronym, but it’s pretty simple. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Essentially, EBITDA is the income you make before subtracting standard costs for taxes, interest, etc. It speaks to how well you run your operations.
Agencies and professional service firms should be able to achieve 20% EBITDA or better. If you aren’t achieving at least 20% — including market-based compensation for owners — it’s likely your staff cost ratio is too high.
If your EBITDA is too low, you will want to understand what is driving the lower-than-desirable performance. Have you invested in staff ahead of the curve? Are you charging enough for the value you are delivering? Did you make investments in marketing that haven’t had the opportunity to pay off yet? These are just some examples of what you should be asking yourself as you interpret your results.
KPIs are interconnected
As you probably noticed, none of these KPIs exist in a vacuum. They are all interconnected, and sometimes, one KPI can help you anticipate the numbers for another (e.g., realization rate and EBITDA ratio). More importantly, these KPIs are vital in understanding your firm’s profitability. When you start paying close attention to the numbers over time, you will know what true profitability looks like and how to better your performance over time.
Depending on the stage of your business and the skill of your finance team, you might be tracking these already but if not, we urge you to start. Clients who opt for the complete accounting department solution from Fiscally know this to be part of their Critical 7 report each month and it has led to a sharper understanding of their business performance overall. If you are interested in how this might help you and your agency we’d love to hear from you!