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How financial KPIs can inform business strategy

Posted by Neha De

June 9, 2022    |     6-minute read (1063 words)

Financial key performance indicators are metrics organizations use to track, quantify and study their financial health. Business owners rely on KPIs to better understand their firms’ financial performance. They can use this information to adjust their goals and come up with strategic objectives.

Business owners most often employ financial KPIs to stay focused on the future, to navigate their companies in the desired direction and to identify critical issues without getting bogged down with the micro details. 

Financial KPIs also tell business owners when operations are running smoothly and alert them to any warning signs or significant changes. 

In essence, financial KPIs help companies:

• Assess whether they are on track to reach their financial goals.

• Evaluate the success of their strategy based on the KPIs.

• Pinpoint areas in the organization that may need an upgrade.

• Ascertain opportunities as well as challenges.

• Gauge whether customers are happy.

15 financial KPIs to determine business performance

1. Gross profit margin – Gross profit margin reveals how much of the total revenue is profit after factoring in expenses such as the total cost of production. A profitability ratio, it calculates what percentage of revenue is left after deducting the cost of goods sold. 

Cost of goods sold comprises all direct expenses associated with a product, that is, the direct cost of production. It does not include overheads such as taxes, operating expenses or interest payments.

Gross profit margin can be calculated using this formula:

Gross profit margin = (revenue – cost of sales) / revenue x 100

2. Net profit – An organization’s net profit explains its bottom line. It is the total cash left over after all bills have been paid. Net profit is also known net income, and accounts for both direct and indirect expenses. 

Net profit can be calculated using the following formula:

Net profit = total revenue – total expenses 

3. Net profit margin – Net profit margin is another profitability ratio that calculates what percentage of revenue and other income is left after subtracting all costs for the business, including costs of goods sold, operating expenses, taxes and interest — and not just the cost of goods sold.

The formula for calculating net profit margin is:

Net profit margin = net profit / revenue x 100

4. Working capital – The working capital of a firm is a measure of its operating liquidity, which can be used for day-to-day operations. 

The formula for calculating working capital is:

Working capital = current assets – current liabilities

5. Quick ratio – Also called an acid test ratio, quick ratio is a liquidity ratio that evaluates a firm’s ability to handle short-term commitments. This metric uses only highly liquid current assets, such as cash, accounts receivables and marketable securities, in its numerator. It is taken for granted that some current assets, such as inventory, cannot easily be turned into cash. 

This is how you arrive at the quick ratio:

Quick ratio = (current assets – inventory) / current liabilities

6. Current ratio – Current ratio is also a liquidity ratio that helps firms understand whether they can pay their short-term commitments with its current assets and liabilities. Organizations can use this metric to find out if they have the required cash on hand to finance a large purchase. 

Current ratio can be calculated using this formula:

Current ratio = current assets / current liabilities

7. Debt-to-equity ratio – This financial KPI is a solvency ratio that measures how much a company finances itself using debt versus equity. The debt-to-equity ratio provides insight into the organization’s solvency status by reflecting the capability of shareholder equity to cover all debt in case of a downturn.

Debt-to-equity ratio can be calculated using the following formula:

Debt-to-equity ratio = total debt / total equity

8. Inventory turnover – An efficiency ratio, this metric calculates how many times per accounting cycle a business sold its full inventory. The inventory turnover KPI provides insight into whether a business has excessive inventory in relation to its sales levels.

Inventory turnover can be measured using the following formula: 

Inventory turnover = cost of sales / (starting inventory + ending inventory / 2)

9. Total asset turnover – The total asset turnover KPI is another efficiency ratio that determines how efficiently a company uses its assets to generate revenue. A higher turnover ratio means a well performing business. 

Total asset turnover can be calculated using the following formula: 

Total asset turnover = revenue / (starting total assets + ending total assets / 2)

10. Return on assets – Another profitability ratio, this financial metric reveals how well the business is at managing its available assets and resources to earn higher profits. 

The formula for calculating return on assets is:  

Return on assets = net profit / average total assets 

11. Return on equity – This is an important KPI to measure if a business has shareholders. It gives an idea of how successful a business is at generating profit for its investors.

Return on equity can be calculated using this formula:

Return on equity = net income / shareholder equity

12. Customer acquisition ratio – This metric indicates how much revenue is earned per new customer. 

The formula for measuring customer acquisition ratio is: 

Customer acquisition ratio = total expected lifetime profit from customer / cost to acquire customer 

13. Operating cash flow – A liquidity KPI, the operating cash flow metric measures an organization’s ability to pay for short-term liabilities with money generated from its basic operations. 

The formula for calculating operating cash flow is:

Operating cash flow = net income + non-cash expenses + change in working capital  

14. Accounts receivable turnover ratio – The accounts receivable turnover ratio calculates how well a firm can collect cash from credit sales. A higher accounts receivable turnover ratio is better for business because it suggests that customers are paying faster. 

Accounts receivable turnover ratio can be calculated using the following formula

Accounts receivable turnover ratio = net credit sales / average accounts receivable

15. Seasonality – This KPI measures how the period of the year is affecting an organization’s financial outcomes and numbers. 

Using financial KPIs to inform business strategy

Once business owners know which financial metrics they need to track for the long-term financial health of their companies, along with how to calculate them and what they tell about their existing business strategy, they can use these metrics to drive their business strategy, that is, how they would work to achieve their business goals. Through the use of the relevant financial KPIs, they can gain insights that might otherwise be missed, helping their businesses grow faster and more efficiently.

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