Note: this was originally published at https://alexoppenheimer.substack.com/
Generally Accepted Accounting Principles (GAAP) were put into effect in 1933, at the tail end of the great depression. These principles aimed to increase consistency, prudence, regularity and continuity to business reporting.
Over the last 88 years, business has undoubtedly changed, and those changes continue to accelerate in the 21st century with new business models driven by the power and availability of technology.
I first learned accounting in college and then learned to apply it and understand it while working in investment banking. I quickly recognized that the standard outputs from the income statement, balance sheet and cash flow statement often do not tell the entire story of a business - especially a fast-growing technology-driven business. There are several metrics that can paint a much more accurate picture than Revenue, COGS and Opex, but are usually business-specific. For example, GMV in a marketplace, ARR for a SaaS business or clicks for an advertising business. All of these metrics are measured, calculated and ultimately disclosed in order to paint a more accurate picture of the economic reality of a business.
When I look at companies, I generally focus on 3 types of “traditional” metrics in order to distill the core economic metrics that most accurately describe a business and allow me to predict what will happen with it in the future:
- Accounting metrics (Revenue, COGS, Opex, Net Income, etc.)
- Cash metrics (collections, outlays, inventory, etc.)
- Operating metrics (users, engagement, ARR, bookings, retention, volume, etc.)
It is a unique combination of these metrics that forms the accurate economic view of a company, and each company is different - even within the same vertical or business model.
When I take an economic view, I focus on things like variable costs vs. fixed costs and NPV of future earnings. Both of these, of course, are directly related to unit economics, and are the underpinnings of why it makes sense to invest in an unprofitable business.
The challenge is that there are no hard and fast rules for which metrics to focus on in order to describe the economic reality of a business because it varies greatly depending on sector, business model, stage, go to market strategy and even the team. And unfortunately there are many ways to do this incorrectly.
Ultimately, these economic metrics need to develop into the standard metrics by which every business gets benchmarked, namely cash generation, in the long term. The hope is that creating the economic-focused picture early will result in the development of a long term business model that can generate cash for its operators and investors by delivering value to its customers through an efficient business model.
I encourage everyone to take an economic view of their business wherein they focus on the value they deliver, how they deliver it and the cost of delivery, but first leave out all presumptions of traditional key metrics. As I always say, the best business models begin as a flow chart.