Financial 101 for Business Owners – Part 2
The 8 Financial Key Performance Indicators Every CEO Needs to Measure
Once your accounting basis is correct and you’re producing the key 3 financial documents, you can analyze a lot about your company’s financial health.
But you still don’t have the full picture.
To really understand what’s going on you need measurements that will tell you how you company is performing in comparison to others in your industry and in comparison to itself over time.
Additionally, you need metrics that reveal the truth about how efficiently and productively you’re doing business.
Enter Key Performance Indicators (KPIs) – the window to the real and changing DNA of your company. We encourage all of our clients to have KPIs, particularly when companies are growing. There is often a lot more to the story than is told simply by a P&L.
Following is an explanation of eight basic (but highly revealing) financial KPIs that every CEO should be examining regularly:
Cost of Goods Sold (COGS) Ratio shows the percentage of sales revenue that’s used to pay for expenses directly related to sales. Here’s the formula:
Cost of Goods Sold / Sales
COGS ratios vary by industry and size. Typically, a larger company may have lower costs on a product due to the volumes. Regardless of what your COGS Ratio turns out to be, determining what it means and what to do with that information requires further detective work. Healthy COGS Ratios vary by industry and are impacted by things like seasonality and consumer buying trends.
Gross Profit is what is left from revenues after direct costs and is the amount available for sales and administrative costs and net profits. The gross profit margin is the percentage of sales left after direct costs (cost of goods sold).
100% – COGS Ratio = Gross Profit Margin
The gross profit margin is especially useful in evaluating profitability after direct costs over time. Obviously, the higher the gross profit the better. Typically gross profits will increase with volumes due to the expected lower unit costs associated with production. Since this ratio is directly related to COGS, it will vary with industry and size. We recommend trending gross profit margins over time and monitor for changes. We also recommend understanding GPM by line of business.
Operating Ratio & Administrative Cost Ratio: This KPI helps you determine if your business is capable of generating a profit by calculating the cost of earning each sales dollar.
To determine your company’s Operating Ratio:
Production Expenses + Administrative Expenses / Net Sales = Operating Ratio
You can also leave out production expenses to match only administrative expenses against sales:
Administrative Expenses / Net Sales = Administrative Cost Ratio
Looking at changes in these ratios is much more useful than taking a single measurement. Seasonal businesses, for example, often compare a month in the current year to the same month in the prior year to give them a better idea of how their company’s financial health is trending.
Current Ratio measures your company’s ability to pay all of its current financial obligations. The formula is:
Current assets / current liabilities
Current assets include cash, accounts receivable and inventory. Current liabilities include accounts payable and credit cards. Generally speaking, a ratio of 1.5 to 3 is preferable. If the ratio is less than 1.0, your company may be struggling with cash or it may be funding growth with debt. If the current ratio is too high, you may be sitting on too much cash rather than investing it back in the business.
Days Sales Outstanding (DSO): This KPI measures the average number of days of sales due from customers. Therefore, it indicates how efficient your company is at billing and collections.
Because it’s more profitable to turn sales into cash quickly, you are looking for a decreasing DSO over time.
To determine your company’s DSO:
Accounts Receivable / Sales per Day = DSO
One reason I like trending ratios is that you can quickly determine if there is a problem. An increase over time in this ratio could mean that it is taking more time to get invoices to customers or that your collections activities are not as effective.
Days Payable Outstanding (DPO): Your business’s DPO is the opposite of its DSO because it indicates how long it takes your company to pay its invoices. You want your DPO to be higher because the longer your company takes to pay, the more opportunities you have to use that money to generate sales.
To determine your company’s DPO:
Accounts Payable / Sales per Day = DPO
Days Working Capital: This KPI tells you the average number of days it takes your company to turn working capital into sales revenue, and is a general indicator of how efficiently you’re using your company’s working capital.
That said, really understanding what your Days Working Capital means is tricky.
For example, if your company’s Days Working Capital decreases it can point to problems maintaining or growing sales, paying invoices too early or taking too long to collect accounts receivables. If it increases, it might indicate high sales growth, taking too long to pay invoices or collecting account receivables quickly.
What’s most important to understand is that your company may fail if it needs more working capital for expansion than it has cash on hand. Most often, this happens when the company uses cash to pay for growth rather than obtaining financing which would make more cash available.
Decreases in Days Working Capital can be an early warning sign that your company is in danger of running out of cash and will fail when it easily could have been profitable – if you had a smarter growth strategy.
The “appropriate” Days Working Capital varies by industry and, therefore, business owners should only assess whether this KPI is high or low against others within the same industry.
To determine your company’s Days Working Capital:
(Average Working Capital x 365) / Annual Sales = Days Working Capital
Net Revenue per Full Time Equivalent (FTE): Net Revenue per FTE is a productivity ratio that indicates how much revenue each employee or team generates, providing data on your company’s efficiency.
Then, use this formula to determine your company’s Net Revenue per FTE:
Sales / FTEs
The higher your company’s Net Revenue per FTE, the more profitable and sustainable your business is.
However, labor-intensive industries typically have a lower Net Revenue per FTE. If this is the case for your company, compare your company’s Net Revenue per FTE to that of other companies in your industry to get a better sense of how efficient your operations really are.
A better way to look at Net Revenue per FTI (as with many KPIs) is over time:
- If Net Revenue per FTE is stable over time, it may mean your business is consistently operating at the same level.
- If Net Revenue per FTE increases over time, you can determine exactly how much you’ve increased productivity.
- If Net Revenue per FTE decreases, it’s a clear sign your business is becoming less efficient.
TIP: Remember, these are 101 explanations of KPIs only – the trick is to simply start measuring (along with the others that follow) to allow the true story of your company to begin to emerge. Once you start measuring these KPIs you are past the biggest hurdle. By doing that, you’ll fast forward your comfort level (more than you might be able to imagine right now) and you can begin to look at the KPI over time, research industry standards, see how changes in variables change your picture in order to make growth decisions, and generally dive deeper into the nuances of the numbers you see. The point is that you have to start somewhere and generating these KPIs (even before you fully understand them) will take you further than you think.
PHEW! Between this and the previous article on accounting format and documents, you have a lot more knowledge about the financial aspect of running your company – and, likely, a good sense of why it’s important to have a financial strategist and accounting person or team you can count on.
The most important thing to remember is that while it is NOT your job as CEO to “run the numbers” (create the financial documents and calculate KPIs), it IS your job to understand what each item is, why it’s important and to use the information you receive in making decisions.
Understanding is the only way to drive up the profitability, sustainability and value of your company.
That said, many CEOs are in the dark about their company’s financial health. They’ve come to their position with an exceptional talent, but most often without the financial background that comes with a degree and real-world experience in accounting and finance.
Do not be embarrassed because you’re not certain where your company stands. Just commit to becoming educated – whatever it takes.
You can learn a lot on your own, through articles like this one, and you can also short cut your education by letting your financial team teach you about the numbers, or by working with an outside strategist who understands both financials and growth strategy – if you want an even bigger picture or if you want to make sure you and your team aren’t missing something.
Whichever path you choose, today is the day to start.
Here’s another resource that will help you uncover potential weak
spots that can prevent you from taking your company to next level:
Tags: Administrative Cost Ratio, Business Growth, CEO, COGS, COGS Ratio, Current Ratio, Days Payable Outstanding, Days Sales Outstanding, Days Working Capital, DPO, DSO, financial growth, Financial Key Performance Indicators, financial management, Gross Profit, growth strategies, Healthy COGS Ratios, Key Performance Indicators, KPIs, Net Revenue per Full Time Equivalent, Operating Ratio, P&L