I’m a big believer in managing your business using your balance sheet first, then your income statement. However, simplifying that by using KPI’s (key performance indicators) can help you get a quick view of your financial landscape and determine your financial health at a glance. Here’s 5 KPI’s that every business owner should use. These are in no particular order, but they cover profitability, liquidity and leverage.
- Working Capital KPI: This KPI is calculated by taking current assets- current liabilities. The more current assets you have in excess of your current liabilities, the more liquid you are. If you liquidated all your current assets would you have sufficient funds to handle all your current liabilities and some money left over. The idea here is do you have enough assets to meet your short term financial obligations?
For example, if your current assets total $500,000 and your current liabilities total $250,000 then your working capital is $250,000 (500-250). You have $2 dollars of current assets for every $1 of current liabilities.
- Return on Equity KPI: This KPI is calculated by taking net profit/shareholder equity. It measures the ability of the company to generate a profit on each unit of shareholder equity. The return on equity not only provides a measure of your profitability, but also the efficiency of the business. An increasing ROE shows shareholders that you’re using their investment to grow the business.
For example, if you had a net profit of $200,000 and your shareholder equity was $500,000, then your return on equity was 40% ($200/$500).
- Debt to Equity (Leverage) Ratio is calculated by taking total debt/total net worth. It measures how the organization is funding its growth and how effectively they are using shareholder investments. A high debt to equity ratio is evidence that an organization is fuelling growth by accumulating debt.
For example, if your total debt is $1 million and your total net worth was $250,000, then your leverage ratio is 4 to 1 ($1 million/250,000). You have $4 of debt for every $1 of total net worth.
- Accounts Receivable Turnover KPI is calculated by taking revenue(annualized)/accounts receivable. It measures the rate at which you collect on outstanding accounts. The problem in maintaining a large bill for a customer is that you are essentially giving them an interest free loan.
For example, if you have $3 million in sales and your accounts receivable balance is $500,000, then your accounts receivable turnover is 6 times ($3 million/$500,000). To convert this in to days, you take 360 and divide it by the turn, 6. With 360/6 = 60 days, this means you have two months of sales outstanding in accounts receivable.
- Accounts Payable Turnover KPI is calculated by taking purchases (annualized)/accounts payable. This KPI shows the rate at which your company pays off suppliers and other expenses. It’s also important for understanding the amount of cash that your business spends on suppliers during any given period.
If your purchases total, $2 million and your payables balance is 200,000, then your accounts payable turnover is 10 ($2 million/$200,000) to convert this to days, take 360/10 and you come up with 36 days of purchase in accounts payables.
You might be thinking, once you calculate these KPI, are my numbers good or bad? Great question! You might want to calculate your KPI’s historically (over the last 3 years or so) to see what direction they’re heading. You may also call your industry association to see if they provide any information on industry KPI’s. I had a mentor tell me one time, you have to “inspect what you expect.” If you can’t measure, you can’t manage it. I hope this article was helpful in giving you some focus on 5 important KPI’s.