Why KPIs are Important to your Business?
In managing a small business, it's important not to rely solely on your intuition. Key Performance Indicators (KPIs) play a crucial role, especially in financial reporting.
To assess your company's financial well-being, it's better to be objective rather than subjective. This ensures that decisions are based on information and data.
Using KPIs is a way to objectively monitor your business's health. These are metrics that assist in tracking progress toward different business goals.
What are Financial KPIs?
Financial KPIs gauge how well a business is doing in meeting its financial objectives. These objectives may include things like total revenue, profit, or the ratio of debt to equity. Financial KPIs provide insights into a business's financial well-being compared to its internal goals, competitors, and other industries.
They are widely used in strategic planning and reporting to guide investment decisions. Monitoring your business's financial performance closely is crucial for long-term success. Below, we'll discuss 11 financial KPIs, how to use them, and additional tips for making well-informed financial decisions.
1. Gross Profit Margin
The gross profit margin indicates the percentage of your revenue that can be considered profit after subtracting the cost of goods sold. It should be sufficient to cover fixed expenses, allowing you to have a profit. This profit can be utilized for activities such as marketing campaigns, dividend payouts, and non-fixed costs.
Calculation: Percentage of (revenue - cost of goods sold) divided by revenue.
2. Net Profit
Your net profit is the final amount of money you have after covering all your costs. It's also called net income and considers both direct and indirect expenses. This is a crucial factor in determining your overall operating cash flow.
Calculation: total revenue – total expenses = net profit
3. Net Profit Margin
Net profit margin reveals the percentage of your revenue that becomes profit. Unlike the gross profit margin, it considers all expenses, not just direct costs. This measure aids in predicting future profits and establishing profitability goals and benchmarks.
Calculation: (total revenue – total expenses) ÷ total revenue = net profit margin
4. Accounts Receivable Turnover Ratio
Your accounts receivable turnover ratio indicates how efficiently you collect cash from credit sales. A higher ratio is preferable, as it suggests that customers are paying you more promptly. This speeds up your cash conversion cycle, meaning cash comes in more quickly.
Calculation: Net credit sales ÷ average accounts receivable = Accounts Receivable Turnover Ratio
5. Current Ratio or Working Capital Ratio
The current ratio measures liquidity. It helps you assess whether you have enough cash available for a significant expense. Creditors may also use it to gauge the probability of you repaying a loan.
Calculation: current assets ÷ current liabilities = current ratio
6. Quick Ratio or Acid Test Ratio
The quick ratio, also known as the acid test ratio, is a crucial measure for a company's financial well-being. It indicates how well a company can settle its short-term debts right away. Unlike the current ratio, which assesses the likelihood of making payments within a year, the quick ratio provides a more precise gauge of this ability.
Calculation: (current assets – inventories) ÷ current liabilities = quick ratio
7. Return on Equity
The Return on Equity KPI indicates how effectively you generate profits from the investments made by shareholders in your business. It reflects the earnings from each unit of shareholder equity, representing total assets minus total liabilities. Simply put, it shows how much profit you make for every pound invested in your business.
Calculation: Net income divided by shareholder equity equals return on equity.
8. Cash Conversion Cycle
The Cash Conversion Cycle (CCC) helps evaluate how efficiently your company transforms working capital into inventory, sells the inventory, and receives cash from the sales. A shorter CCC indicates better effectiveness in selling products and converting those sales into working capital.
Calculation: Days inventory outstanding + Days sales outstanding – Days payable outstanding
9. SG&A Ratio
If you want to reduce expenses, consider analyzing your Selling, General, and Administrative (SG&A) Ratio. This ratio highlights the percentage of your sales, general, and administrative costs that aren't directly related to producing your product. These expenses may include miscellaneous office costs that can impact your profits. In general, a lower SG&A ratio is preferable, indicating more efficient cost management.
Calculation: Divide total SG&A expenses by total sales to get the SG&A ratio
10. Creating a Budget Timeframe
The budget creation cycle provides unique insights compared to the usual ratios and outcomes discussed in this article. Despite the differences, its significance should not be overlooked. Understanding how swiftly you can generate a company budget variance using past data reflects your grasp of your business model, operations, sales growth, return on equity, and your company's financial efficiency.
Calculation: Days for preparing, authorizing, and implementing the budget = Budget Creation Cycle
Importance of Tracking KPIs with Financial Software
In addition to common financial metrics and KPIs, businesses might also track specialized indicators that focus on their internal functions, like analyzing inventory, sales, receivables, payables, and human resources. Instead of manually calculating these metrics from general ledger accounts, many businesses use software to automate the process and create dashboards with all the important numbers in one place.
Accounting and financial management software often comes with real-time dashboards and KPIs tailored to different roles and industries. Users can easily add custom KPIs to meet specific requirements or goals. The information is automatically updated as the software processes transactions and other financial data.
Financial KPIs and metrics are essential tools for leaders and staff to quickly grasp how well their company is doing and monitor any important changes over time. They also help leaders set key objectives and keep employees focused on measurable goals. Using financial software with automated, accurate, and real-time KPIs is crucial for the company to make progress towards its goals without being overwhelmed by excessive data.
To ensure your business stays on the right track, it's vital to regularly monitor specific KPIs. Short-term KPIs offer insights into your current financial situation, aiding in making immediate decisions to propel your business forward. For long-term success, concentrate on KPIs that guide your overall strategy. These KPIs assist in assessing if you're moving towards your financial goals and evaluating the effectiveness of your strategy.