How to READ an INCOME Statement
Learn the Basics of an Income Statement To Calculate the Commercial Ratio
The Commercial Ratio is a holistic measure in that it looks at the total growth within a specific period divided by the Sales and Marketing Expense within that same period. This is important as a measure to investors who are looking at how efficiently a company's commercial system is driving value to gauge the return on their investment.
There are many financial statements inside a company, including the Balance Sheet and Cash Flow Statement. For the purposes of calculating the Commercial Ratio, we only need to concern ourselves with the Income Statement.
Mapping The Commercial System to the Income Statement
This is important as a financial measure of Sales & Marketing productivity and can be derived from looking at the Income Statement.
example: saas company
Cost of revenue is associated with the run rate from the previous period while sales and marketing expense is associated with the growth achieved in the current period.
Sales and Marketing costs may be one line item (which makes finding the denominator easy) but some companies include them in 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.
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.
Unsustainable
0 - .75
System: Wasteful, inefficient
Environment: Reactive
Activities: Maximum conflict
Balanced
.75 - 1.25
System: Optimized
Environment: Proactive
Activities: Minimum conflict
Too Safe
1.25 - 2.0
System: Under-invested
Environment: Lacking innovation
Activities: Lethargic
The Commercial Ratio measures how well you are communicating value to customers. Value translates to Revenue Growth period over period. The level of investment should at least be offset by the growth achieved within the same period.
Every business is different, but these provide simple metrics to say what we should be looking at and where we should be focused.
What if they were at 1.0?
This matters because the significant financial impact of the improvement in commercial ratio. In terms of revenue, getting to one in this example can generate an additional $94.92 million in revenue. From a cost savings side, getting to 1 means a $84.9 million dollars savings in cost.
The Impact
The punchline is that growth increase could drive $521.27 million in increased market capitalization.
WHAT IF THEY ARE AT LESS THAN 1.0?
One of the more interesting side effects of a low Commercial Ratio is the compounding negative implications, or "The Snowball Effect." When a Commercial Ratio is less than one, the expense required to generate that new revenue growth must be recovered in future years of operation to meet investor expectations.
This creates a debt. It might not be a financial debt, but it creates a gap. That gap works like a tax. When you spend too much each year on revenue acquisition, it puts more pressure on other parts of the business.
With each consecutive year that this happens more and more debt is pushed to other operational elements of the business, creating more stress across the whole business. The only reliable level for other functions is to cut costs, which creates a vicious cycle. If you run your organization in the red (below .75 of the Commercial Ratio) you create an increasingly rigid and siloed organization unable to respond to changing market conditions.
Connecting Process Elements with the Income Statement
Audience
The focus of the whole process. They are a group of people whom your salespeople must persuade to get a contract.
Interactions
Interactions should add up to a contract. Contracts add up to revenue.
Messengers
Customers hold the salespeople the most accountable for their overall experience with the company. Their salaries, commissions, T&E, and incentives are all expenses.
Messages
All of the packaging, tools, constant, collateral and training salespeople receive are all messages that cost money (expenses) that salespeople must match to specific customer situations.
Measure the System
The Commercial Ratio measures the efficiency of the whole system.
How to Calculate the Commercial Ratio
For Sales and Marketing professionals who are new to financial accounting, it's easy to get lost in the details and terminology.