Financial performance assessment: Top KPIs to track and measure
Financial performance assessment: While you are engaging in your business operations, devising new robust strategies, and innovating
some path-breaking products or services, you must not forget to understand the impact of all of the above on your business growth. These affect the financial health of your business and help you earn more profits or result in losses. You must keep a regular check on your financial performance through key financial indicators. You can use these key financial metrics to measure the success of your strategies and operations and take corrective actions whenever and wherever required.
Gut instinct also works sometimes; however, in the case of financial reporting, it is best to put your bet on financial performance measures. Financial performance metrics are defined as indicators companies use to track, measure, and analyze the financial performance of the company.
The company sets financial goals in terms of profits or revenues to compare the performance in comparison to other companies, industries, or some internal goals. Financial performance indicators generally help the investors decide whether to invest or not and in strategic planning.
Knowledge of these financial metrics is essential to gauge the business’s performance and then make relevant adjustments to the goals and strategic objectives of different functional teams and the organization as a whole.
The key financial metrics generally are segmented under different categories of liquidity, efficiency,
profitability, solvency, and valuation. Managers and other stakeholders of the organization must focus on the following key financial indicators:
Profitability: key financial indicators
Gross profit margin
It indicates the effectiveness of the company in generating revenues with due consideration to the costs of production of products and services that are used to generate those revenues.
This financial indicator is generally compared with the industry average to match how the company is performing against its competitors. If the gross profit margin is lower, then the company may be under-pricing; if the performance measure is higher, then the company must control its overhead costs.
Net profit margin
It gives a good assessment to the investors looking for investment opportunities. Through this financial metric, investors can gauge whether the management of the company is capable of generating enough profits from the sales without going overboard with the operating costs and overhead expenses.
A good net profit margin differs by industry and the business structure. Generally, an industry average is defined, and players can compare their net profit margin to the industry average to compare their performance with that of the competitors.
If the company has a high net profit margin, it means the management is effective in cost control while a lower net profit margin indicates either poor pricing strategies or ineffective cost structure, or both.
Return on equity
It is a ratio used for comparing the competitors since it is used to gauge which company is capable enough to generate cash internally.
If ROE is gradually decreasing, it means that the company is not capable of using its equity capital efficiently, while if it increases gradually, that means the company’s management is efficiently using the shareholder capital for generating profits.
Return on assets
It indicates how efficient a company’s assets are in generating revenues, meaning from each currency unit of assets they possess, how many currency units of earnings are generated.
A higher ROA number indicates that the company is effective in generating more money from investing less. The return on assets figure differs from industry to industry.
There are industries, which require a large initial investment. In such cases, the ideal ROA of the industry is less. For example, the return on assets for the services industry is higher while it is comparably lower from transportation and utility companies, as they need high investment initially.
Liquidity: key financial indicators
It is calculated as current assets divided by current liabilities. Investors and analysts use this financial metric to understand if the company is capable enough to maximize the current assets on its balance sheet to fulfill short-term obligations such as current debt or any other payables.
Generally, a current ratio between 1.2 and 2 is considered as the optimum value. If a company has a current ratio below one, it means that the company does not have liquid assets to fulfill its requirement of short-term liabilities.
A company with a current ratio of two has twice the current assets as compared to the liabilities to cover its short-term debts. However, a too high value of the current ratio is also not good since that indicates that the company is incapable of using its current assets efficiently.
It measures the ability of a company to use its quick assets to fulfill its current liabilities. The quick assets here include cash and cash equivalents, accounts receivable, and marketable securities.
In general, a ratio of one or higher is considered a good quick ratio. It is a more conservative measure as compared to the current ratio. A lower quick ratio means the company has several unpaid bills, lesser sales, and poor collections of accounts receivable.
Another point of concern is when the quick ratio is significantly lower than the current ratio. In such a case, it means that the company lacks liquid assets to cover its short-term liabilities, and therefore, relies heavily on inventory, which should not be the case.
Leverage: Key financial indicators
Debt to equity ratio
An ideal debt to equity ratio varies from industry to industry, depending on the usage of fixed assets in that industry. Generally, the ideal debt to equity ratio must not be more than two, except for some asset-intensive industries such as mining.
A too high debt to equity ratio means a company is unable to pay its debts due to financial distress situation, while a too low debt to equity ratio means that the company is over-dependent on its equity to finance the business. Both the situations are bad for the company ad must be avoided.
Generally, the debt ratio is industry-specific; however, a ratio of less than or equal to 20% indicates a healthy company, while if the ratio is higher than 30%, then the company is in distress and must take immediate actions for improvement.
Investors use this ratio to assess the risk level of a company. If the company has an extremely high debt ratio, it must take measures to increase the sales, lease more assets of the company, or must issue new or additional shares to improve its cash flow in the company.
Efficiency: key financial indicators
Asset turnover ratio
The higher the value, the efficient the company is in generating revenue from its assets, while a lower ratio value indicates the inefficiency of the company in using its assets to generate sales. Like many other ratios, the ideal asset turnover ratio differs by industry since some industries are asset- intensive while some require fewer assets.
If the total asset turnover is declining over time, the company can improve its figures by increasing sales, selling assets, automate the inventory management system, find efficient use of its assets, and accelerate collections.
Inventory turnover ratio
It indicates the number of times the company uses or sells inventory in a given defined period, specifically a year. In the general sense, it is a measure to check if the company has an excess inventory as compared to its sales figures.
For most industries, a good turnover ratio lies between 5 and 10. This number indicates that the company is not required to place frequent orders with the suppliers and has enough inventories on hand to satisfy the demands.
A higher number indicates a more efficient organization since it is capable enough to save on storage costs and other holding expenses. Low inventory turnover means the company is overstocking and unable to sell its products.
Other key financial indicators
Customer acquisition ratio
The numerator of the formula includes the average purchasing price of the customer and the purchasing frequency, while the denominator includes all the marketing and onboarding costs. However, the components making up the numerator and denominator differ from industry to industry.
A high customer acquisition ratio means you are earning higher profits from every one unit of currency that you spend on acquiring a new customer. On the other hand, a low ratio means your investment in acquiring a customer is not fruitful enough to generate profits for your business, and you are losing money.
Budget variance is a key financial indicator for any business. It is calculated as subtracting the actual
spend from the planned budget for each item in the budget over a defined period. To calculate the percentage variance, divided the above number by the original budgeted number.
If the actual revenue is more than the budgeted revenue or if the actual costs are less than the budgeted costs, then the budget variance is considered favourable. In the case of the opposite
situation, the budget variance is unfavourable. An unfavourable budget variance depicts poor management decisions.