One of the risks that it is essential that a business owner avoids is to equate their business being busy to it being healthy.
A bulging order book and working seven days a week does not necessarily ensure to financial wellbeing.
This is where Key Performance Indicators (KPIs) play their part. KPIs in themselves can be used to measure performance in any area of a business from Sales and Marketing to Operations to HR to Finance.
Monitoring the financial performance is vital to ensure long-term success. Whilst there is almost an endless list of potential measures, these are the seven financial KPIs that we would recommend that you set and monitor to enable you answer the question ‘is my business on target?’
Gross Profit Margin
The Gross Profit has to cover the operating costs of the business, building funds for the future and leaving a distribution to reward the investors.
The Gross Profit Margin illustrates whether you are pricing your products or services correctly as a whole to cover these and can be measured against an industry or sector benchmark. In addition, it can give an indication of the viability of a specific product or service within your range.
The calculation for Gross Profit Margin is (Revenue – Cost of Goods Sold) / Revenue
Net Profit Margin
This will show the percentage of your revenue that was profit and, again, can be measured against industry standards as well as for budgeting and forecasting.
Net Profit Margin is (Revenue – Cost of Goods Sold – Operating Costs – Interest – Taxes) / Revenue.
One key point is that the Net Profit Margin does not a measure of the level of the cash generated in the period. This is as a result of the inclusion of a number of non-cash expenses in the Operating Costs, principally depreciation and amortization.
Current Ratio and the Quick Ratio aka the Acid Test
The Current Ratio highlights the ability of your business to pay its way by calculating the Current Assets (Cash, Accounts Receivable, Stock and Inventory) / Current Liabilities (Accounts Payable and Other Short-Term Creditors).
An adequate Current Ratio is sector specific but, largely, a ratio between 1.5 and 2 indicates a healthy business.
A low Current Ratio tends to flag that there is either inadequate credit control, an issue with stock management or an unsustainable cash burn rate.
The Quick Ratio is a more conservative measure of financial wellbeing than the Current Ratio because it excludes Stock and Inventory from the Current Assets. As a result, this gives a more realistic view of the ability of your business to meet it’s short-term obligations. A Quick Ratio higher than 1 implies that this would be the case.
Accounts Receivable Turnover
The Accounts Receivable Turnover shows the number of times per year that the business collects its average accounts receivable and will aid in determining the efficiency of the credit terms and collections. To extract the maximum value, this needs to be measured on a monthly or quarterly basis.
The simple calculation for Accounts Receivable Turnover is Net Annual Credit Sales / ((Opening Accounts Receivable + Closing Accounts Receivable) / 2)
For example, a business with annual credit sales of £450,000, and opening Accounts Receivable balance of £55,000 and a closing Accounts Receivable balance of £70,000 would have a turnover of 7.20. In other words, the average account receivable was collected in 50.7 days.
Return on Equity
Measuring the level of profit generated in relation to the monies your shareholders have invested provides a gauge on both profitability and efficiency.
The calculation for Return on Equity is Net Profit / Total Equity and a high or improving ratio validates to backers that their monies are being employed wisely.
All these mathematical ratios count for nothing unless your customers are satisfied with the products or services that you are providing and it is key to engage with them on a regular basis for their feedback.
Finally, Have a Damn Fine Accountant that will work with you not only in crunching the numbers but also in putting the measures in place to support your business grow and prosper.