The power of the magnitude ratio in driving revenue growth

While COVID-19 has certainly been a disruption to the private equity landscape, the primary goal of PE firms remains the same: Strive for smart investments that deliver outstanding returns.

The days are behind us when PE investors could rely solely on financial engineering and cost cutting to drive outperforming returns to LPs.  In today’s unprecedented market, purchase price valuations in many industries remain high, which in turn, requires greater amounts of value creation during the hold periods of portfolio companies to ensure outperforming IRRs are achieved.  One of the many “levers” that can be pulled is revenue growth, which is one of the most effective options when executed successfully.

Despite the economy’s roller-coaster ride in 2020, PE professionals need to hold their operating company managers accountable to organic revenue growth goals. (It is important to distinguish between organic growth and inorganic growth, of which, the former will be the focus of this discussion.) To facilitate realistic revenue growth goals, metrics must be calculated, tracked and reported to help drive behavior and accountability throughout the organization. But how do managers or owners know what metrics to focus on when so many are out there?

It is important to know the magnitude of effect that each metric has against the revenue growth of the business. At Baker Tilly, we refer to this degree of effect as the “magnitude ratio” of that particular metric. The magnitude ratio calculates the amount of incremental revenue that results from every 1% improvement for the metric being analyzed, and then dividing the incremental revenue amount by the total existing revenue. The resulting percentage is the “magnitude ratio” of that KPI. For example, if you have a $100 million revenue business, and a 1% improvement in a particular KPI will drive incremental revenue by $3.5 million, then the magnitude ratio of that metric is 3.5%.

Once metrics are analyzed in this fashion, it quickly becomes clear which metrics an organization should prioritize for integration. Just as importantly, it clarifies which metrics should be ignored. For example, a product warranty business with large call-center operations was tracking sales personnel productivity and salesforce employee turnover as their primary KPIs to support their organic growth goals. After a detailed magnitude ratio analysis, these two metrics had ratios of 1.3% and 0.3%, respectively. Further analysis showed that the renewal rate of existing contracts, with a magnitude ratio of 2.3%, would be a more effective metric to focus on. The company began tracking this metric and installed an incentive plan for managers and sales reps around renewal rate improvements.