If you are a business owner, then you might relate to the fact that the biggest stressor for you is managing your business finances efficiently. However, to manage or improve your financial performance, first, you need to effectively measure it from every possible aspect.
In order to make that happen, you first need to identify the key performance indicators and then effectively implement them in your business. But what exactly are key performance indicators and how can you measure them?
This blog will answer all of these questions in a meticulous and comprehensive manner.
To begin with, key performance indicators are the quantifiable metrics that assist you in tracking the performance of your business. Similarly, financial KPIs are the metrics that give valuable insights to effectively track the financial performance of your business in terms of your overall business efficiency.
Probing further, below are some of the crucial KPIs that will help you in measuring and effectively achieving your financial business goals and objectives.
7 Important Financial KPIs to Track Business Performance
1. Return On Assets(ROA)
Every company invests a lot of money in building effective assets in order to earn profits. But how exactly do you measure whether those heavy investments are giving you profits in return or not? That is where the role of financial KPI Return on Assets comes into light. It assists in measuring the effectiveness of assets or resources in comparison to the value generated from them in a particular period of time. The more ROA the better efficiency. Most industries consider 10% – 20% as a good return on investments.
Probing further, given ahead is the formula that will assist you in calculating the ROA of your business.
- Return On Assets = (Net Income ÷ Total value of assets) ×100
Example of ROA
Let’s assume that your manufacturing company has a total investment of $170,000 on the company’s assets and resources in one year and managed to collect a net income of $900,000 in the same period of time. By applying the formula, the percentage of return on assets will be
- (170,000 ÷ 900,000) ×100 = 18.8%
2. Gross Profit Margin
Gross Profit Margin is the amount of money left with the company after the subtraction of the total cost of goods sold from the total revenue. It is one of the essential performance indicators of finances because it assists in reflecting the efficiency of business operations in generating healthy profits which further assist in the growth of the company.
In order to calculate the percentage of gross profit margin, apply the formula given below
- Gross Profit Margin = (Net income – Cost of goods sold ÷ Net income) ×100
Example of Gross Profit Margin
Let’s say your company had a net income of $140 Billion in one year and the total cost of goods sold in the same year was $ 94 Billion. Hence, by applying the formula, the gross profit margin of your manufacturing company, in this case, would be
- (140 – 94) ÷ 140 × 100 = 32.8%
3. Cash Conversion Cycle (CCC)
Cash Conversion Cycle or Cash Cycle refers to the time period in which you give out your money in the form of investments and you receive that money as revenue after selling the final products. It is another vital KPI because it assists in identifying the number of days it takes for your company to liquify your assets and liabilities into cash. If your company takes less number of days, it indicates more efficiency of your distribution operations. The formula of CCC goes like this,
Cash Conversion Cycle = (DIO + DSO) – DPO
- DIO stands for Days Inventory outstanding (days the company holds the inventory before selling it)
- DSO stands for Days Sales Outstanding (days it takes a company to collect due payments from stakeholders)
- DPO stands for Days Payable Outstanding (days a company takes to clear all the outstanding bills and invoices)
Example of Cash Conversion Cycle
Let us suppose that it takes 78 days for your company to clear out all the items in the inventory and it takes you 90 days to collect all the credits from your stakeholders. Furthermore, you almost spend 23 days clearing out all the pending bills of your company. Hence, according to the formula, your cash cycle will be,
- 78 days + 90 days – 23 = 145 days
4. Operating Cash Flow Ratio
The Operating Cash Flow Ratio refers to the ability of your company in paying off all the liabilities from its current cash flow generated from your different business operations. Liabilities in this metric refer to the various amounts that are due in the form of accounts payable or short-term debt. Calculating and tracking the ratio of operating cash flow can assist in providing solid insights into a company’s liquidity. When the cash flow is good, companies can aim for business diversification strategies to grow revenue streams.
Probing further, the formula for calculating the operating cash flow ratio is
- Operating Cash Flow Ratio = Cash Flow from Operations ÷ Current Liabilities
Example of Operating Cash Flow Ratio
Let’s assume that the total cost of cash flow of your operation is 147 million in one year and the sum of all your liabilities including all your debts is almost 89 million in the same year. Hence, the operating cash flow ratio will be
- 147 ÷ 89 = 1.65
5. Accounts Receivable Turnover
Accounts Receivable Turnover Ratio which also goes by the name of Debtor’s turnover ratio is a metric that measures a company’s ability to collect its debts or receivable accounts within a given period of time. A lower ratio depicts higher efficiency and vice versa.
For calculating the Accounts receivable turnover ratio the formula is,
- Accounts Receivable Turnover = Net sales ÷ average account receivables
Example of Accounts Receivable Turnover Ratio
Hypothetically, the net sales of your company were $500,000 and the average accounts receivable for the same period of time were $32,100. Therefore, the turnover ratio will be
- $500,000 ÷ 32,100 = 15.
6. Budgeted Variance
Budget Variance is the amount of difference between the planned budget and the actual earnings of a company in a given period of time. To simplify, it can assist you in tracking the overall performance of the company by comparing the actually generated sales to the predicted earnings. The variance can be positive and negative as well.
The budgeted variance percentage can be calculated with the formula given below,
- Budgeted Variance = Generated sales – (Budgeted sales ÷ Budgeted sales) × 100
Example of Budget variance
You decided at the beginning of the fiscal year that you will make a sale of $450,000, however, by the end of the same year, your company managed to generate a sale of $430,000. It clearly depicts that variance is not in your company’s favor, however, to calculate the exact variance,
- (430,000 – 450,000)÷ 450,000 × 100 = – 4.44%
7. Acid Test
An acid test or Quick Ratio is a measure that calculates the company’s efficiency in converting its short-term assets to clear out all outstanding liabilities. Major companies rely on long-term assets to generate money, hence, selling off short-term assets does not cause much loss. These short-term assets can include marketable securities, accounts receivable, or short-term investments are done by the company.
To calculate the Quick Ratio,
- Quick Ratio = (Short term investments + Marketable securities + accounts receivable) ÷ Cost of current liabilities
Example of quick Ratio
Your manufacturing company did short-term investments of $40,000 and marketable securities were equivalent to $35,000 and along with this, the outstanding accounts receivable were $24,000. Moreover, the cost of your total liabilities is $120,000. Hence the quick test will be,
- (40,000 + 35,000 + 24,000) ÷ 120,000 = 0.825
To encapsulate, managing the financials of the company is really crucial to measuring the progress and growth of the company. Hence, it is really crucial for your business to efficiently identify the key performance indicators and implement them accordingly to get the insights crucial for the progress of the company.