How to Calculate the Commercial Ratio
25 Essential Steps to Finding the Commercial Ratio
For sales and marketing professionals who are new to accounting language and financial statements, it's easy to get lost in the details. Grounding yourself in the purpose of the Commercial Ratio will help you focus on the numbers that matter most.
In order to measure something, you need to define its purpose. The Commercial Ratio is based on the assumption that the purpose of Sales and Marketing is to drive Revenue Growth.
All companies have “reporting periods.” A reporting period is when a company must report its earnings to the government (SEC for the US). All public companies must report once each quarter.
At a simple level, these companies are providing “financial reports.”
Financial reports are comprised of: A Balance Sheet. A Cash Flow Statement. An Income Statement.
A Balance Sheet shows what a company is owed and what it owns (assets, liabilities, and owner’s equity).
A Cash Flow Statement summarizes your incoming and outgoing money from operations, investing, and financing.
An Income Statement summarizes income and expenses during a set period of time.
Our goal is to measure the effectiveness of both Sales and Marketing. All the spending in these departments show up on the Income Statement. For the purposes of calculating the Commercial Ratio, we are only focused on that one thing.
The Numerator: Revenue Growth
To measure Revenue Growth, we have to compare periods.
A “period” is only a unit of time. We are comparing different units of time.
Periods can be any unit of time as long as they are the same (day, week, month, quarter, year, etc.).
Periods are often used in analytics and forecasts so it is important to make sure your data is well aligned or you cannot perform "apples to apples" comparisons.
To evaluate Sales and Marketing as a whole, we look at comparing 12 month periods.
TTM means “trailing twelve months.”
We don’t always use TTM. When companies report their financials from 2020, we will use 2020 revenue.
We are using TTM now simply to be as up-to-date and capture as much of the COVID-19 impact as possible. COVID-19 didn’t affect 2019 – so if we use the last 12 months, we get great insights.
So we calculate Revenue Growth by subtracting the past period's revenue from the current period's revenue.
Revenue Growth = (TTM or current period revenue) – (past period revenue)
The Denominator: Sales & Marketing Expense
We are looking for both Sales and Marketing costs.
There is a business process in finance often called the “roll up” where they take all of the individual budgets companies have and merge them into the categories of an Income Statement.
It is important to understand this. Why? Because most Sales and Marketing professionals understand their “budgets” and have no idea how much other spending is happening in other departments. The Sales and Marketing spending is not a “budget,” it is a reporting of all the budgets.
Think of it like this: the Army has no idea how much the Navy or Air Force spends so they don’t have much empathy for “total defense spending” when they ask Congress for more money. But to you and I, we see 25 percent of all government spending is on the military and we outspend all the countries in the entire world combined!
This is where things get technical. There is something called GAAP (Generally Accepted Accounting Principles). These are merely rules to follow. Companies are allowed to account for spending differently, they just need to be consistent.
This means that some companies could argue some of their Sales and Marketing spending is “cost of revenue.” However, this includes the total cost of manufacturing and delivering a product or service to consumers. For the purposes of the Commercial Ratio, we are only concerned with Sales and Marketing costs.
Companies can choose to break out Sales and Marketing costs in one line item (which makes finding the denominator easy).
However, some companies put Sales and Marketing costs into a spending bucket called SG&A (Selling, General, and Administrative).
When Sales and Marketing are accounted for in the spending bucket called SG&A, we have to estimate the Sales and Marketing spending for the current period.
We do this by estimating 12-15 percent from the SG&A number accounts for General and Administrative spending and 85 percent Sales and Marketing spending.
For example $1,000,000 SG&A x .85 the estimated amount of Sales and Marketing spend = $850,000 Sales and Marketing Expense.
Now divide Revenue Growth (The Numerator: Step 5) by Sales & Marketing Expense for the current period (Step 9 above) to calculate the Commercial Ratio.
Most people get lost in the simplicity. The Commercial Ratio only measures Sales and Marketing productivity.
The Commercial Ratio is simple. What makes it complex:
Every company is different. Find a friend in finance to make sure at the simplistic level that you know what’s going into each bucket and know what are the financial rules associated with the Income Statement.
There are specific rules (that if you know then they are easy).
Companies have different fiscal years so we have to be smart with comparing time periods.
There are a lot of specific terms for financial reports. It’s easy to think you need to know them. You do not.
Most people get lost in the simplicity (because of the details). The Commercial Ratio only measures Sales and Marketing productivity.