Think Like a Manager: Understanding the 5 Financial KPIs Affecting Your Business
Every company needs concrete information on its performance(operational, marketing, financial and so on) to understand whether it is meeting established targets. KPIs convey this information, and they are typically presented in the form of numbers for precision and exactness.
There are different types of KPIs, based on various functional areas of a business. A financial KPI is a quantifiable measure that tells companies whether they are meeting their financial goals.
Organizations use financial metrics to track and analyze their financial health. In this post, we take you through the key financial KPIs that businesses across the board track.
What are the most important financial KPIs?
1. Revenue Growth
To survive and thrive, you must successfully sell you products and services. Revenue growth is the increase or decrease in a company's sales from one period to the next. It is critical for the following reasons:
- To acquire new talent
- To develop new capabilities
- To build additional products
- To fund investments
- To acquire assets
Revenue growth: (Current year revenue - Previous year revenue)/Previous year revenue
This is a year-on-year measure. You can apply the formula to compare how sales fared in the financial quarter of one year to the same quarter of the year prior to it.
A decline in revenue growth needs to be investigated. Common reasons for a sales slowdown include:
- Dissatisfaction with the company's products/services
- Misalignment between marketing and sales
- A weak digital marketing strategy
- New competitors with better value propositions
- Poorly trained staff
- Leadership failure
Systemic issues, diminished competitiveness and strategic ineffectiveness should be tackled on a priority basis. If sales are growing but targets are unmet, then companies may pursue the following tactics:
- Increasing the number of customers
- Increasing the average transaction size
- Increasing the frequency of transactions per customer
- Increasing product/service prices
Building financial acumen among teams not directly involved in financial management or strategic decision-making is essential to bringing everyone on board to support ambitious revenue targets. Employees will feel even more motivated to act when they understand how their performance bears out on the company's financial results. Financial KPIs enable this understanding and help foster a growth mindset.
2. Profitability Ratios
Profitability ratios belong to a class of financial KPIs that evaluate a company's ability to generate income during a specific period of time. Broadly, they can be categorized into:
- Margin ratios, the ability to generate profits as a proportion of revenue
- Cash flow ratios, the ability to convert revenue into cash
- Return ratios, the ability to generate returns for shareholders
- There are different types of margin ratios. For financial KPI analysis, the most important ones to consider are:
- Net profit margin, a measure of the net income or profit generated as a percentage of revenue.
- Net profit margin = (Net profit/Revenue) x 100
- Operating profit margin, the profit your company makes from its operations minus its day-to-day running costs (operating costs).
- Operating profit margin = (Net profit + tax +interest)/Revenue x 100
- EBIDTA (earnings before interest, taxes, depreciation, and amortization) * margin, a measure of your company's operating profit as a percentage of its revenue.
- EBIDTA margin ratio = (Net profit + interest + tax +depreciation + amortization)/Revenue x 100
* Interest refers to the expenses arising from paying off the interest on business loans
Taxes are expenses resulting from payment of business taxes
Amortization refers to the cost of intangible assets over time
Depreciation is the gradual decrease in the value of a company's assets.
Under return ratios, return on equity (RoE) is a commonly tracked financial KPI.The RoE indicates how successfully the company is generating returns on the investment it received from shareholders. It is tracked against earlier periods or against the industry benchmark.
- RoE = (Net profit/Shareholder equity) x 100
The net cash flow is among the most important financial KPIs to track as it tells you whether you have a cash deficit or sufficient cash on hand. A negative net cash flow implies that you may be spending more money than you make over a specific period.
- Net cash flow margin = (Cash inflows - Cash outflows/Larger of the cash outflow or inflow) x 100
3. Working Capital
Your company's working capital is the difference between its current assets and current liabilities. Assets are all the resources that the company owns as a result of its transactions; prepaid expenses that haven't yet expired, and costs that have a measurable future value. Liabilities include loans, mortgages, bonds, warranties (cash reserves to honor the obligation to repair or replace defective products), accounts payable (amount owed by company to its creditors) and accrued expenses, which are expenses that are due to be paid.
Why is it important to understand your working capital?Because it can help you avoid cash flow problems and utilize the money you have to innovate, enhance capabilities and grow.
4. Inventory turnover
If you're a manufacturer, inventory turnover will be among the chief financial KPIsto track. It informs you how often you're selling off your entire in-stock inventory in a year, helping you understand whether you're holding on to excessive inventory relative to your sales levels. Moving inventory efficiently is important as you don't want to incur a high inventory carrying cost while the value of that inventory decreases over the same time.
Inventory turnover = (Total sales - Cost of sales)/(Inventory remaining at the end of the year)
5. Current Accounts Receivable and Accounts Payable
Accounts Receivable is the money your debtors owe you.Accounts Payable is the money you owe to your creditors. The financial KPIs tell you how long it takes your business to pay its creditors and to collect your money from customers. In this sense, they are vital aspects of cash flow management.
Ready to start using financial KPIs and building financial acumen?
Keeping tabs on financial metrics is not just a managerial responsibility. Knowledge of key KPIs and financial KPI analysis can help teams understand the reasoning behind budgeting and cost management, and review financial performance more easily to plan efforts, make suitable changes, and support tactical initiatives.
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