6 Financial KPIs to Track Progress and Profitability
There are many ways for owners to measure progress in their businesses that, when put together, give them a better idea of their big picture. And tracking financial KPIs is one important piece of this puzzle.
Today, I’m going to share with you six financial KPIs that are important for small business owners to keep their eye on. But before we dive too deep, let’s define KPIs and why they matter for your business.
What are KPIs?
KPI stands for Key Performance Indicator. Each part of your business could have its own specific measures that you can track to compare where the business is today compared with your long-term goals. Think of them as a short-hand way to keep your eye on the critical elements that will drive success or indicate trouble for your business. Simply put, each KPI is a quick picture of performance related to a specific business objective that is tied to the success and profitability of your company.
Essentially, they are targets that you are working towards — milestones that measure progress toward specific goals and objectives. KPIs can be developed across different functional areas of the business and are a great way to focus your team on achieving measurable success!
The best way to start using KPIs in your business is to select a small number of indicators that feel important and meaningful and make the results of those indicators transparent to everyone. Transparency can be accomplished with a shared google sheet, a whiteboard, or an online platform designed for exactly this purpose. But like most new projects or ideas, it’s best to start small and keep it simple!
Of course, as CFOs, we love the financial metrics (no surprise!). So here are a few of our favorite KPIs that help us understand the financial health of virtually any company.
Financial KPIs That Measure Profitability
Profitability simply means the extent to which the company is able to bring in more money than it spends from its operations.
By looking at your income statement, you can track your company's revenue and expenses and determine whether the company is generating a profit or a loss.
There are two key ratios that we love to use to measure profitability, and they are relatively easy for you to calculate on your own.
Gross Profit Margin
Your gross profit margin is the amount you earn on each item or service sold after subtracting the specific costs related to the sales of that product or service.
For example, if your business is generating sales of $150,000 and those sales have a cost of $75,000 related to them, your gross profit is $75,000.
Expressed differently, for $150,000 in sales, 50% of those sales are your gross profits. Meaning for every dollar of revenue you generate, 50% of it is left over after sales-related costs.
Depending on the type of industry you are in, your target gross profit margin will vary. The gross profit serves as the source for paying operating expenses, so ideally, you want to have gross profits that are higher than your operating costs to be profitable.
This leads us to the next ratio — which is your net profit margin.
Net Profit Margin
Your net profit margin is how profitable your business is after paying all of its expenses. It is an extension of the gross profit margin calculation because it takes your gross profit margin and subtracts all of the expenses.
For example, if your business has a gross margin of $75,000 and all of your expenses are $40,000, your net profit is $35,000.
Expressed differently, for $150,000 in sales, 23% of those sales are your net profits. Meaning for every dollar of revenue you generate, 23% of it is left over for profit!
Your gross profit margin can be improved by increasing price, sales volume, and cost of sales.
Your net profit margin can be improved by decreasing your operating expenses and identifying more operating efficiencies in your business.
Financial KPIs That Track Cash and Liquidity
Cash flow is the movement of money into and out of your business. It is another key concern for small business owners because, as we all know by now, cash is queen!
Cash is the lifeblood of your business, so monitoring it to understand how and when it is being utilized is key to creating more financial stability for your business.
Two ratios that we often use for cash management are the current ratio and days in A/R (“Account Receivable”).
Current Ratio
The current ratio compares your cash and accounts receivables to your bills and short-term debts. It measures how liquid your business is, which is your ability to pay off your short-term liabilities.
For most businesses, one important goal is to make sure you have more cash plus accounts receivables than you the number of bills due in the near future.
This ratio is calculated using your balance sheet and divides your total Current Assets by your total Current Liabilities. The higher the current ratio, the greater the “cushion” you have between current obligations and the ability to pay them.
Typically, a current ratio of 2 or more is an indicator of good short-term financial strength.
Days in Account Receivable
Days in A/R measures how long it takes to clear your accounts receivable. It is the number of days that an invoice will remain outstanding before it’s collected.
This ratio is an easy way to determine how effective your business is at collecting timely from its customers.
You calculate this ratio by dividing your accounts receivable by your revenue for the same period and multiplying that number by 365. This allows you to arrive at the average amount of days it typically takes to collect an invoice.
A good practice to do is to compare this with your invoicing terms to see how they compare. If the ratio is higher than your stated terms, it may be a sign that your accounts receivable process may need to be strengthened.
These two ratios can be used as financial KPIs in your business to measure how effectively your business is managing cash, making short-term spending decisions, and collecting from your customers.
Your current ratio can be improved by increasing your price and sales volume and reducing your costs of sales and other operating expenses. Your days in A/R can be improved by creating a better process around handling your accounts receivable, such as following up more frequently with overdue accounts and instituting late fees to encourage timely payment.
One thing to note about both the Profit and Cash KPIs listed here: They are taken from the financial reports and the timeliness of these results is dependent on your bookkeeping and accounting procedures so if you get your financial reports each month you can only update the KPIs monthly. By definition when looking at these indicators you’ll be looking at the past and using it to try and make decisions about current and future actions.
However, you can also identify and track KPIs that are Leading Indicators — meaning they tell you from day to day how the business is doing rather than waiting for those month-end reports.
KPIs That Measure Sales
Sales-related metrics are excellent leading indicators. Sales and the rate of growth in sales are important measures of the health of your business. The more sales you make, the more revenue you generate — which leads to growth and profitability in your business. But while the total dollar amount of sales each week or month is important, the underlying process of how you reach that goal is also important to track.
Setting specific sales KPIs can help you to measure the effectiveness of your marketing and pricing strategies as well as the performance of your sales team.
Two of our favorite KPIs to use related to sales activities are average order value and sales conversion rate.
Average Order Value
Average order value (AOV) helps you to understand, on average, how much each customer typically spends and is an indicator of your customers’ behavior.
It is calculated by taking the total amount of sales for a period of time (week or month) and dividing it by the number of customers serviced or orders placed for that same period of time.
The higher the AOV is, the more each customer is worth and the more profitable your business can be after its costs of sales.
A common way to increase AOV is to offer volume discounts to your customers, incentivizing them to increase their order value for a reduced price. Another way online merchants increase AOV is by offering related products as add-ons to items already in your cart.
Sales Conversion Rate
Sales Conversion Rate helps you to measure how many new leads (potential customers) are converted into paying customers, which is important in understanding the effectiveness of your marketing and sales efforts.
It is calculated by taking the total amount of sales (of your product or service) and dividing it by the number of potential leads for a specific period.
This percentage can be used to evaluate the effectiveness of your current marketing strategies and your customer journey.
Here’s a quick recap of the KPIs we’ve covered:
All of these financial KPIs combined give you, as the small business owner, a solid picture of the state of your business and where you can make shifts to improve your profitability, cash management, and sales.
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