When running a small business, you can’t rely on your gut instinct all the time, especially when it comes to evaluating your company’s financial health. 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 the use of key performance indicators, otherwise known as KPIs. Different types of KPIs represent an array of markers that companies use to measure performance in a variety of areas — from marketing campaigns to supply chain management to finance.
According to KPI.org, KPIs “are the critical (key) indicators of progress toward an intended result. KPIs provide a focus for strategic and operational improvement, create an analytics basis for decision-making, and help focus attention on what matters most.”
Keeping close tabs on your small business’s financial performance is essential to long-term success. Below, you’ll find eight actionable KPIs that will help you measure your business’s financial health.
1. Gross profit margin
Your gross profit margin provides you with a percentage, indicating how much of your revenue is profit after factoring in expenses like the cost of production and sales. The formula to calculate gross profit margin is:
Gross profit margin = (revenue – costs of goods sold) ÷ revenue
Costs of Goods Sold are all the direct expenses associated with the product. It does not include things like interest payments, taxes, or operating expenses.
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.
Typically, you want your gross profit margin to be at least 10%. Anything lower than that may be cause for concern. Gross profit margins can also vary considerably by industry. For instance, engineering and construction firms have an average gross profit margin of 12.15%. 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. Net profit accounts for both direct and indirect expenses. The formula for calculating net profit is straightforward.
Net profit = total revenue – total expenses
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.
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.
Net profit margin = (total revenue – total expenses) ÷ total revenue
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.
Like with gross margins, net margins also vary by industry. 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 28.54%, but the average net margin is only 3.10%.
4. Aging accounts receivable
If your business involves sending bills to customers, an accounts receivable aging report can be eye-opening. This KPI is not so much a metric with an equation. Instead, it’s a report that lists unused credit memos and unpaid customer invoices. This report can be particularly useful for those with cash flow problems, as it can identify the root cause of the problem.
If customer A consistently pays her bills within 15 days, while customers B, C, and D drag their payments out to 90 or even 120 days, you may have found a root cause of your business’s cash flow problems. You can then take steps to start charging interest on overdue accounts or let go of slow-paying clients.
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.
Current ratio = current assets ÷ current liabilities
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.
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:
Quick ratio = (current assets – inventories) ÷ current liabilities
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.
Customer acquisition ratio = net expected lifetime profit from customer ÷ cost to acquire customer
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.
If your firm is healthy, this ratio will be at least one. If it’s 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 investment for research and development
Another key metric that you can consider is return on investment (ROI) for research and development. This can include a broad range of expenses. For instance, let’s say that you’re focused on customer outreach and want to see if your research efforts are worthwhile. You’d be able to make that determination with this KPI.
ROI of research and development = (Gain from investment – cost of investment) ÷ cost of investment
There’s no black and white answer as to what a good ROI is. If you’re in the 5% range, you should be comfortable that your efforts are paying off. Anything lower than that and you may want to evaluate whether you should reallocate your R&D funds.
Which KPIs are best?
The eight KPIs above can go a long way toward helping you track your company’s financial health. A good KPI is one that is measurable and that 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.
Start defining KPIs for your business
When determining which are the right KPIs for your business, you should ask yourself a few 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.
KPIs Can Help Your Business Reach New Heights
If you’re trying to make strategic decisions for your company, you should first use Key Performance Indicators. These measures can help you better understand the ins and outs of your company. Before selecting a financial metric, be sure to outline your business objectives so that you can determine which KPI targets are most relevant to your needs and goals.
This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.