May 17, 2018 Accounting & Finance en_US Your business's financial health is everything, but many small business owners don't look at the full picture when looking at their expenses or key performance indicators. Adjusting these financial KPIs and the cost it requires to achieve them are what can make or break a business What Financial KPIs Should Your Small Business Focus On?
Accounting & Finance

What Financial KPIs Should Your Small Business Focus On?

By Cathie Ericson May 17, 2018

When you run a small business, it’s easy to focus on what you’re making, what you’re spending and how much is left.

Those financial key performance indicators (KPIs) are important, but when viewed independently, they only tell one piece of the story, rather than the entire book. Maintaining a successful business entails understanding not only what the financial KPIs are, but realizing how they are connected to the financial health of your business.

CEO Richard Hayman, of Hayman Consulting Group, found that taking a deeper look at one key metric led to a greater grasp of how his business was truly performing.

“If the company made $10 million this year and $5 million last year but I brought home the same amount, it meant I was working twice as hard for the same compensation.”

By measuring his yearly take home and comparing that figure with the company’s annual revenue,he was able to determine if company growth meant more money or just more work.

That was the wakeup call he needed to realize why it was crucial to pay attention to how his financial KPIs were performing year over year.

“That number was a starting point to tell me if I was heading in the right or wrong direction,” he said, which allowed him to pinpoint changes that would yield better results.

Which Financial Key Performance Indicators Matter?

Whether you’re a five-person landscaping business or a 50-person jewelry retailer, the same handful of metrics come into play. Here are the “Great Eight” to be aware of:

1. Accounts Receivable

Accounts receivable is money you’ve already earned and for which you’ve invoiced your customers.

For example, if your plumbing company did $10,000 worth of work this month and your customers paid you for half of it at the time of service, with invoices sent for the other half, your accounts receivable would be $5,000.

2. Accounts Payable

This is how much money you owe to suppliers and other creditors. (Note: Although payroll is also money that you owe, it is a separate line item than accounts payable.)

Using the same plumbing company as an example: If you had purchased materials on account for the jobs you completed totalling $2,500, this would be tracked in Accounts Payable until the debt is paid.

3. Cash Flow

This shows the relationship between money that is coming in and going out. It gives you a picture of how much money you have in the bank available to you at any specific time.

Cash inflow comes from the sale of your goods or payments received for your services.

Cash outflow is the money you spend to provide those goods or services.

This is tracked in a Cash Flow Statement, which when used with Balance Sheets and Income Statements, gives a full picture of your business’s finances.

4. Cost of Goods Sold (COGS)

Cost of goods sold are all of the direct costs that are specifically tied to the creation and production of your product.

These include raw materials, labor, and financed equipment directly involved in the production of your product.

5. Operating Expenses (OE)

These are the necessary fixed and variable costs that are part of running your business that aren’t related to what you’re producing, also called overhead.

Examples of fixed operating expenses include:

  • Rent
  • Electricity
  • Internet
  • Server Costs

Examples of variable operating costs include:

  • Shipping
  • Paper
  • Printer Ink
  • Marketing

6. Gross Profit Margin (GPM)

Gross profit is the money left over from revenue after accounting for the cost of goods sold.

The gross profit formula is: R (revenue) – COGS (Cost of goods) = GP (Gross Profit)

Gross profit margin is calculated by dividing the gross profit by revenue.

The gross profit margin formula is: GP (Gross Profit) / R (Revenue) = GPM

For simplicity’s sake, let’s say a single baker, who owns all of their equipment outright, earns $10,000 in revenue in a week, and the cost of ingredients to create all of the baked goods was $6,000.

The gross profit calculation would be: $10,000 – $6,000 = $4,000

While the gross profit margin would be: $4,000 / $10,000 = 0.4 (or a 40% gross profit margin)

However, this isn’t the full picture.

In reality, if the baker hires an assistant, and is still financing their equipment, the cost of goods sold increases while the gross profit margin decreases.

Here’s an average breakdown of the cost of goods sold:

  • Head Baker’s Weekly Pay: $628
  • Baker’s Assistant Weekly Pay: $354
  • Weekly Cost For Equipment Financing: $827
  • Ingredients: $6,000

Adding all of these weekly costs up, the total cost of goods now equals $7,809.

Using the same formulas as before:

(Revenue) 10,000 – (Cost of Goods) $7,809 = $2,191 (Gross Profit)

(Gross Profit) $2,191 / $10,000 (Revenue) = 21.91% (Gross Profit Margin)

A common mistake many small business owners make when calculating their gross profit margin is to look only at the materials (or in this case ingredients) without factoring in the labor and production costs.

Making this mistake creates an inflated sense of what your gross profit margins are, and can have an extremely negative impact in future calculations.

7. Net Profit Margin & Net Income (NI)

This figure is your bottom line: It tells you how much you are making after all costs have been accounted for, including both direct costs and indirect costs from taxes to interest.

To calculate net income, start by using the figure from your gross profit calculation:

(R) Revenue – (COGS) Costs of Goods Sold = Gross Profit

Then subtract any operating costs, expenses, interest, depreciation, and finally taxes. The resulting number is your net income.

8. Cash Burn Rate

Cash burn rate, or negative cash flow, indicates how fast you are spending capital, especially startup capital, before generating positive cash flow from operations.

This is generally quoted as the cash spent per month, so if a business spends $10,000/month, the negative cash flow is $10,000.

Burn rate is the benchmark for determining a company’s runway, or the amount of time a company can spend before it runs out of money.

So if a company has $100,000 in the bank, and spends $10,000/month it’s runway would be 10 months: (100,000 / 10,000 = 10 ).

How You Can Tweak the Metrics for Maximum Value

Now each of these financial KPIs taken separately only shows you one piece of the puzzle—a snapshot, rather than a video. But what small businesses need to remember is that they are all interconnected in the quest to drive a business forward.

Often, it can be just a few minor changes to key performance indicators that can have a positive effect downstream.

Here are four places to start:

1. Closely Monitor Accounts Receivable

“If I had a sufficient number of orders on hand, I would sleep well, and if not then I was a nervous wreck,” Hayman says. But then came the next hurdle—collecting on those sales.

He found that most small businesses don’t run accounts receivable properly, which causes them to run short of cash. Having a process for ensuring that invoices are paid promptly is key to keeping your accounts receivables healthy.

To that end Hayman points out that you have to be diligent with your collections from the start.

“You only have one opportunity to train a company about how you want to get paid, and that’s when you send your first bill,” he says. “If you wait 60 days to chase down that initial invoice, they will assume that is your pain point.”

Instead, he created a proactive system.

  1. Call a new customer to alert them the bill is coming.
  2. Call the day the invoice arrives to check on bill delivery and see if they have any questions.
  3. If they haven’t paid on time, call the day after it’s due to see if any questions had arisen or if there was another reason they hadn’t yet paid.

“They already told me the bill had arrived and they had no questions, so there was no reason it shouldn’t have been paid,” he says.

2. Manage Direct Costs Through Managing Inventory

Pre-sold inventory is the best kind, but that’s not always possible. Unfortunately many companies end up with too much inventory on hand, which can wreak havoc on your cash flow.

By managing how fast you go through your inventory, you can keep the right amount on hand but not be saddled with the cost of carrying excess.

Make sure not to rely on an inventory figure without ensuring all the inventory is sellable. “Unless you’ve been in the warehouse and seen what’s there, you might not realize that much of your existing inventory could be obsolete,” Hayman points out.

Creating and maintaining a solid system, for example, storing inventory by date, can ensure that all your inventory is good.

If you need to divest of some inventory? Find creative ways to make as much money as you can from unsold inventory from offering deep discounts to loyal customers to selling it online to find a new customer base.

3. Reduce Expenses Whenever Possible

At the end of the day it’s all about cash, says Brian Cairns, CEO of ProStrategix Consulting Inc.

“Zero cash equals bankruptcy,” he says, adding that few small businesses are in a position to manage several months of negative cash flow. “By then, it becomes really hard to reverse course and save the business,” he cautions.

That’s where planning comes in: If you know that there will be a heavy investment period or an anticipated drop in revenue, plan for the burn appropriately and cut back on marketing expenditures or overtime pay, for example.

And don’t hesitate to check the little things.

Challenge yourself to find small ways to reduce your expenses, from managing indirect costs by cutting down on office supplies or lowering your energy bills with more mindful usage. Reach out to your suppliers for a break or shop your account around to minimize your direct costs.

Any step you can take to reduce your burn rate will pay off in more attractive cash flow.

4. Find Ways to Sell in Bulk or Offer Subscriptions

Regardless of your industry there are large consumers who, when incentivised, will be able to make sizable or ongoing purchases.

  • Gas stations offer fleet accounts to taxi services.
  • Office supply companies have tiered rates for supplying large offices.
  • Furniture companies strike deals with hotels to furnish their multiple rooms at a discount.
  • Consultants have larger clients that pay a more sizable retainer than their standard account.

If your business is not currently capable of large purchase orders, consider creating a subscription for a selection of your inventory that has the highest repurchase rate.

  • Hardware stores offer propane tank refills at a discounted rate.
  • Clothing retailers have seen increased popularity of subscription style boxes.
  • Cosmetics companies offer subscription services for product samples or excess stock.

These large guaranteed or recurring accounts offer great cash flow predictability and can finance a significant portion of your ongoing operations.

5. Be Proactive at Every Step

The best advice, says Hayman, is to anticipate a problem long before it happens and then work to avoid it, rather than dealing with it once it arrives.

“Small companies should remember that they have a big advantage over a large corporation in that they can run their business how they choose, and pivot when they need to,” he says.

While big corporations are focused on each quarter and immediate shareholder expectations, a smaller company can look toward the future and make changes designed to benefit them for the long-term.

That includes taking a hard look at the financial KPIs that matter and making sure they are working together smoothly to propel you down the path to success.

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Cathie Ericson is a freelance writer who specializes in small business, workplace issues, personal finance and health. She lives in Portland, Ore. @CathieEricson Read more