When running a small business, you can’t rely on your gut instinct all the time, especially when it comes to financial reporting. You should be objective rather than subjective when determining the financial health of your company.
One way to objectively track the health of your business is through key performance indicators, otherwise known as KPIs. KPIs are metrics that can help you chart progress towards a variety of business goals — from marketing campaigns to supply chain management and finance.
What are financial KPIs?
Financial KPIs measure business performance against specific financial goals such as revenue or profit. They show the financial health of a business against internal benchmarks, competitors, and even other industries. Financial KPIs are widely used in strategic planning and reporting to help people decide where to focus their investment.
Keeping close tabs on your small business’s financial performance is essential to long-term success. Below, you’ll find eight important financial KPIs that will help you measure your business’s financial health and boost your growth rate.
What are the key metrics to focus on?
1. Gross profit margin
Your gross profit margin shows how much of your revenue is profit after factoring in expenses like the total cost of production. Shown as a percentage, the formula to calculate gross profit margin is as follows: (revenue – cost of goods sold) ÷ revenue = gross profit margin.
Cost of goods sold are all of the direct expenses associated with a product. It does not include things like interest payments, taxes, or operating expenses.
So for instance, imagine that you earn $1 million in total revenue for the year. The direct costs associated with your product are $400,000. The equation would then look like this: gross profit margin = ($1,000,000 – $400,000) ÷ $1,000,000 = 60%
Your gross profit margin should be large enough to cover your fixed (operating) expenses and leave you with a profit at the end of the day. You can then use the extra earnings for things like marketing campaigns, dividend payouts, and other non-fixed costs.
Pro tip: Typically, you want your gross profit margin to be at least 10%.
Anything lower than that may be cause for concern. But remember, gross profit margins can vary considerably depending on your business model or industry. For instance, engineering and construction firms have an average gross profit margin of about 12%. Banks, on the other hand, have 100% profit margins. So long as you’re hitting or exceeding your industry average, you’re in good shape.
2. Net profit
Your net profit is your bottom line — the amount of cash left over after you’ve paid all the bills. Also known as net income, net profit accounts for both direct and indirect expenses. It is an important component of operating cash flow. The formula is simply: total revenue – total expenses = net profit.
For example, if your sales last year totaled $100,000 and your business expenses for rent, inventory, salaries, etc. added up to $80,000, your net profit is $20,000.
There is no exact amount that specifies what a “healthy” net profit is. However, as a rule of thumb, you’ll want to make sure that you have a net profit instead of a net loss. Strong revenue growth may not be good for your business if your costs are too high.
Pro tip: Don’t confuse net profit with operating profit.
Operating profit, also known as operating income, excludes costs such as debt and taxes while net profit includes all business costs. Another measure of operating profit is EBIT, which is Earnings Before Interest and Taxes.
3. Net profit margin
Net profit margin tells you what percentage of your revenue was profit. However, unlike the gross profit margin, it accounts for all expenses, not just direct costs. The formula for calculating net profit margin is as follows: (total revenue – total expenses) ÷ total revenue = net profit margin.
In the example above, let’s say that you earn $1 million in revenue. However, after accounting for non-operating expenses, your total expenses are $950,000. You determine that: net profit margin = ($1,000,000 – $950,000) ÷ $1,000,000 = 5%.
This metric helps you project future profits and set goals and benchmarks for profitability. After comparing this to the gross profit margin in the previous example, you feel as though your net profit margin is too low. You know that the fundamental change between the two formulas was the addition of non-operating expenses. You may want to consider cutting back on non-essential costs to improve your net profit margin.
Pro tip: Like gross margins, net margins can vary by industry or business model.;
So be careful which businesses you benchmark against. It’s also reasonable to expect net margins to be considerably lower than gross margins. For instance, the average gross margin for the advertising industry is approximately 29%, but the average net margin is only 3%.
4. Accounts receivable turnover ratio
Your accounts receivable turnover ratio measures how well you collect cash from credit sales. The formula for the ratio is: net credit sales ÷ average accounts receivable = accounts receivable turnover ratio.
To calculate net credit sales, simply exclude returned items from your total. To calculate your average accounts receivable value, add your beginning balance to your ending balance and divide the total by 2. The period of time between each balance could be one month or a fiscal year.
A higher ratio for accounts receivable turnover is better than a lower ratio because it shows your customers are paying you faster. In turn, this accelerates your cash conversion cycle. As we’ve seen above, ratios can vary significantly between different industries and business models but they are usually higher for low-cost goods and services.
Pro tip: check your aging accounts receivable report.
Even if you have a good accounts receivable turnover ratio, it’s possible to still have some very late-paying customers. Your ratio won’t necessarily show this, so it’s important to also check your aging accounts receivable report to find unused credit memos and unpaid customer invoices. This report can be particularly valuable if you have cash flow problems because it identifies the root cause.
5. Current ratio
Current ratio provides you with a measure of liquidity. You can use this KPI to determine if you have the necessary cash on hand to fund a large purchase. Creditors may also use this formula to determine the likelihood of you repaying a loan. The formula is: current assets ÷ current liabilities = current ratio.
Current assets are things like cash and other assets that you expect to be converted to cash within one year. Current liabilities are debts that you expect to repay within a year.
The resulting number should ideally fall between 1.5% and 3%. A current ratio of less than 1% is significantly concerning, as it means you don’t have enough cash coming in to pay your bills. Tracking this indicator may give you a warning of cash flow problems.
Pro tip: Use the working capital formula to calculate the amount of liquidity in your business.
To calculate the amount of working capital in your business, rather than your ratio of liquidity, use the working capital formula: current assets – current liabilities = working capital.
6. Quick ratio
The quick ratio is another KPI that’s extremely relevant to a business’s financial health. The quick ratio shows a company’s ability to pay short-term financial liabilities immediately. The quick ratio is a better indicator of the ability to do so than the current ratio, as the current ratio accounts for a business’s likelihood of making these payments within a year.
The formula for quick ratio is: (current assets – inventories) ÷ current liabilities = quick ratio.
Pro tip: the quick ratio is also known as the “acid test ratio.”
You may also see people refer to this KPI as the acid test ratio. That’s because acid tests are designed to produce quick results, much like this ratio. Essentially, this KPI is a measure of a company’s immediate liquidity and cash on hand.
7. Customer acquisition ratio
Another way to measure financial health is to compare how much revenue you receive per new customer. This KPI is easy to set up. The formula is: net expected lifetime profit from customer ÷ cost to acquire customer = customer acquisition ratio.
To calculate the expected lifetime profit from the customer, you’ll need to consider a customer’s purchasing frequency and average purchasing price. Your costs to acquire the customer can include things like marketing and onboarding costs. The actual variables that make up these components will vary from company to company.
Pro tip: If your firm is healthy, this ratio will be at least one.
If your customer acquisition ratio is less than one, it’s an indication that you’re spending too much to acquire customers and losing money as a result. A high ratio, on the other hand, means that your investment is worthwhile. For instance, imagine the equation yields a customer acquisition ratio of three. This means that you’re earning $3 for every $1 you spend to acquire a new customer.
8. Return on equity
If you have shareholders, another key metric to look for in your financial data is your return on equity (ROE). The formula is: net income ÷ shareholder equity = return on equity.
This KPI shows how successful you are at generating profit from shareholders’ investments in your business, because shareholder equity represents total assets minus total liabilities. In other words, it reveals how much you make from each dollar invested in your business.
Pro tip: ROE can measure performance between companies in different industries.
While most financial KPIs provide internal benchmarks or performance benchmarks against competitors, the return on equity KPI can create comparisons across different industries based on how well companies use investors’ money.
How to measure KPIs
The eight formulas provided above will all help you to measure your performance against business metrics. The critical question is which ones you should choose for your business.
A good KPI is one that is measurable and relates directly to your strategic goals. However, not all KPIs are necessarily the same. The needs of one business might vary from those of another. For instance, a brick-and-mortar store may not focus as much on customer acquisitions or website traffic, just like an e-commerce company wouldn’t concentrate on sales per square foot.
You’ll want to consider where your company is in the business process when choosing KPIs. For instance, if you don’t have a deliverable product yet, you don’t need to worry about KPIs like cost per acquisition, number of customers acquired, or lifetime value. Focusing on relevant KPIs will help streamline the decision-making process.
Lastly, you’ll want to make sure that your performance measurement includes both leading indicators and lagging indicators. Lagging indicators involve things that have already happened in the past. KPI examples of lagging indicators include total sales last month and income per employee. Leading indicators, on the other hand, are important metrics that keep track of inputs, allowing you to determine how likely you are to meet your strategic goals. Conversion rates are an excellent example of a leading indicator.
6 questions to ask when defining KPIs for your business
When determining which are the right KPIs for your business, you should ask yourself the following questions:
- What is the ultimate goal that you’re looking to achieve?
- Why is this goal relevant?
- What objective information can you use to define progress and success (or failure)?
- What variables will influence the outcome of this goal?
- When will you know that you’ve achieved your goal?
- What time frame would you like to use for measuring your goal?
For instance, imagine you notice that your revenues are down for the year. You want to track sales KPIs to help improve your annual income. You decide to add “Sales Growth” to your KPI dashboard. Your goal is to increase revenue by 10% over the next six months, a relevant goal because it will allow your company to become more profitable
You determine that you can measure your progress toward this goal by tracking an increase in revenue versus an increase in dollars spent. You then realize that hiring additional sales staff and focusing on customer satisfaction and retention can help you achieve these goals. You’ll know after six months whether you’ve completed this goal, although you’ll check in every four weeks for a real-time depiction of how you’re doing.
Using these criteria ensures that you’re creating SMARTER KPIs. SMARTER stands for:
Choosing SMARTER KPIs ensures that these key metrics are working well for you, increasing your chances of meeting your short-term and long-term goals.
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