Financial performance assessment: Top KPIs to track and measure

Financial performance assessment: Top KPIs to track and measure
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

Gross profit margin is one of the key financial indicators that indicate the profitability of a company. The profitability is calculated as the gross profits as a percentage of revenue. Therefore, the formula for gross profit margin is the difference between revenue and cost of goods sold, divided by revenue.

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

Net profit margin is a key financial metric, calculated as the net profit as a percentage of revenue. It is a measure of profitability, as the gross profit margin. It indicates how much of each unit of money earned in revenues by the company translates into profits.

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

Return on equity (ROE) is one of the key financial indicators for a business in terms of profitability. Return on equity is calculated as the division of net income by shareholder’s equity. It indicates how efficient a company is in generating returns on the investment that is received from the shareholders of the company.

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

Return on assets is a key financial metric that measures the profitability of a business. It calculates the profitability of a company in comparison to its total assets. The formula for return on assets (ROA) is net income divided by total 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

Current ratio

The current ratio is categorized as a key performance measure of liquidity. It measures whether a firm is capable enough to meet its short-term obligations.

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.

Quick ratio

The quick ratio is one of the key financial indicators that measure the liquidity of a company. It is similar to the current ratio, except that it excludes the inventories and prepaid from current assets.

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

The debt to equity ratio is one of the key financial metrics of leverage of a company. The formula for debt to equity ratio is a company’s total liabilities divided by the shareholder’s equity. This ratio indicates how much shareholders’ equity and debt are used to finance the assets of the company.

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.

Debt ratio

Debt ratio is another leverage-measuring indicator. It is calculated as total debts divided by total assets. It indicates how much of a company’s assets are financed by the debts it takes.

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

Asset turnover ratio, also called total asset turnover, is a key financial indicator to measure the efficiency of a company. It measures the efficiency of a company in generating sales revenue from its total assets. The formula for asset turnover ratio is net sales divided by the average total assets.

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

The inventory turnover ratio is one of the key financial metrics that measure the efficiency of a company. It is calculated as the net sales divided by the average inventory at the selling price.

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

Customer acquisition ratio is one of the key financial performance measures to identify how much revenue you are generating from every new customer that you acquire. The formula for customer acquisition ratio is net expected lifetime profit from customer divided by the cost to acquire a customer. The ideal customer acquisition ratio is one.

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

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.

Conclusion

There are many other key financial indicators in addition to the ones stated above. However, it depends on your industry of operations, goals, and objectives. Nonetheless, they are significant for any business to measure growth, success and design future business strategies.