What Financial Performance Metrics Should Small Businesses Monitor?
Small businesses face various challenges, most of them affecting their finances. Unlike medium and large businesses, small businesses are highly vulnerable to the effects of poor decision-making and inept financial management. Bad decisions arise when managers or decision-makers use outdated, irrelevant, or inaccurate financial data that is based on estimates and assumptions.
Small businesses must design and implement an organized financial structure that aligns with business goals and objectives to accurately estimate business performance. This can only be achieved by using tools that track business performance, especially financial health. Financial KPIs (key performance indicators) are just one of the many tools that allow you to quickly assess the financial health of a business.
What are financial KPIs?
Key financial performance indicators are specific metrics businesses can use to track or monitor their financial health. These metrics measure how well your business is performing against various financial goals, such as profit and revenue. As such, you can use them to compare the financial well-being of your small business against various internal and competing benchmarks.
Small businesses should consider financial KPIs when developing strategic plans. Businesses can use them to determine the best times to invest. As such, tracking these KPIs is important for long-term business success.
What are the key financial KPIs to focus on?
Small businesses should keep an eye on the following key financial metrics;
- Gross margin
Gross profit margin is the percentage of profits over total income of income. To find this value, you need to deduct the cost of goods and other expenses, such as the cost of production. As a percentage, you can calculate the gross profit margin of your business as follows:
Gross profit margin = (Revenue – total cost of goods sold) ÷ Revenue
As mentioned, cost of goods sold includes all the direct expenses associated with the products. It does not include other expenses, such as taxes, interest payments, and operating expenses. If you earn $ 1 million in revenue for the year ending and the direct production costs are $ 400,000, your gross profit margin would be;
(1,000,000 – 400,000) ÷ 1,000,000, or 60%.
For companies making a profit, the gross profit margin should be large to cover fixed expenses, and the surplus stays in the form of profit. You can use the extra amount to fund your marketing campaigns, pay dividends, and other costs.
Your gross profit margin should be at least 10%. Anything less than that should be a cause for concern. However, keep in mind that gross profit margins vary depending on your business model and industry. For example, construction companies and engineering companies can have gross profit margins of 12%. In contrast, banks have more than 90% of margins.
- Net profit
Your bottom line is the amount of money you have left over after paying all of your business bills. Also referred to as net income, net income includes direct and indirect business expenses, which is an important factor in calculating operating cash flow. To calculate net profit;
Net Profit = Total Income – Total Expense
For example, if your annual sales total approximately $ 200,000 and the rent, inventory, employee salaries, and other expenses total $ 120,000, your net profit for the year is $ 80,000. Unlike gross profit margin, no exact amount is considered “healthy” profit. However, as a general rule, you need to make sure that your business is making a profit.
- The net profit margin
The net profit margin informs companies what percentage of turnover was profit. Unlike gross profit margin, net profit margin includes direct costs and all business expenses. The formula for calculating the net profit margin is as follows:
Net profit margin = (Total income – Total expenses) ÷ Total income
Using the example above, suppose your income is $ 1,000,000, direct costs are $ 400,000, and non-operating expenses are $ 200,000, your net profit margin will be as follows;
($ 1,000,000 – $ 600,000) ÷ $ 1,000,000, or 40%.
Calculating the net profit margin helps predict future profits. For example, based on the example above, the net profit margin is much lower than the gross profit margin in example one. However, the only addition to the calculation is that of non-operating expenses. To increase your profit margin, you need to find ways to cut down on non-essential expenses.
- Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the effectiveness of collecting cash from credit sales made. The formula for calculating this ratio is as follows;
AR turnover rate = Net credit sales ÷ Average accounts
Remember to exclude any returned items when calculating your net sales on credit. Likewise, to determine the average accounts, add your opening balance to the closing balance, then divide by two. A high accounts receivable turnover rate is preferable because it shows your credit customers are paying faster.
- Current ratio
The current ratio is one of the key performance indicators and important metrics for financial services that measure the liquidity of the business. You should use this metric to determine if you have enough money to fund large purchases. Creditors also use this metric to determine the likelihood that a business will repay its loans. The current ratio is calculated as follows;
Current ratio = Current assets – Current liabilities
Short-term assets are everything, including cash and business assets, that can be quickly converted into cash. On the other hand, liabilities are debts or credits that must be repaid within the year. A healthy business should have a current ratio of between 1.5% and 3%.
You should be concerned if your current ratio is less than 1%, as that means you don’t have enough money to pay your bills. Tracking this metric provides a good warning of impending cash flow problems.
- Quick report
The rapid ratio is another relevant KPI used to monitor the financial health of companies. This metric is closely related to the current ratio, as it assesses a company’s immediate ability to pay off short-term debts. However, the quick ratio is better than the current ratio because it only shows the probability of the business to pay its debts during a fiscal year.
Quick ratio = (Current assets – Inventories) ÷ Current liabilities
Most people call the quick report an acid test report. This is because the acidic tests produce quick results just like the quick report.
- Customer acquisition rate
Another effective way to measure the financial health of your business is to calculate the revenue received from each new customer. Calculating the customer acquisition rate is very simple.
Customer acquisition ratio = Expected net profit over the life of a customer ÷ customer acquisition cost
The main challenge is to determine the expected net benefit of the customer over the lifetime. However, you can do this by monitoring customers’ average purchase price and purchase frequency. On the other hand, customer acquisition costs include marketing and integration expenses. These variables vary from company to company.
A customer acquisition rate of less than 1% means that you are overspending on acquiring customers who are not spending a lot on your business. A corresponding high ratio shows that your customer acquisition efforts are worth it.
- Return on equity
Return on equity is another important metric, especially for companies with shareholders. The formula and method for calculating return on equity are as follows;
Return on equity = Net income ÷ Equity
This metric shows how your business has benefited from shareholder investments. Note that shareholders represent total assets minus liabilities of the business, and it shows the profits made from shareholders’ investment in your business.
Which metric should you use?
While all of the above-mentioned KPIs are important business financial metrics, which one should you be using in your business? Good and effective metrics should be measurable and directly linked to your strategic goals. Unfortunately, not all metrics are the same. Also, your business should be different from that of other businesses.
For example, physical businesses will not focus on customer acquisition ratios. Likewise, an e-commerce store will not monitor sales per square foot. You need to assess your business and business processes when choosing financial KPIs. For example, if you currently don’t have any deliverables, you shouldn’t worry about some KPIs, such as the cost per acquisition ratio. Instead, focus on the relevant KPIs to streamline your decision making.
Additionally, you need to make sure that your financial performance metrics show both leading and lagging indicators. Lagging metrics are things that have happened before, such as total sales from previous months or individual employee income. On the other hand, leading indicators are metrics that monitor inputs and help achieve strategic business goals. A good example of a leading indicator is the conversion rate.
Consider the following questions to determine the best KPIs for your business;
- What are your ultimate goals?
- Why are these goals relevant?
- What objective information do you use to define success or failure?
- What variables determine the outcome of your goals?
- How will you know if you have achieved the goals set?
- Is there a timeframe for measuring these goals?
For example, if you notice that your annual income has dropped, you should follow the sales metrics to improve your annual income. You should include “sales growth” on your business KPI dashboard with the goal of increasing revenue by 20% in six months.
When choosing appropriate financial KPIs to monitor the financial health of your business, make sure that the metrics you choose are measurable and provide accurate information. As mentioned, one metric may be relevant to your business and not relevant to another due to varying business needs. It is important that you use relevant KPIs according to the specific needs of your business.
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