In order to manage it, you need to be able to measure it. This management axiom is at the heart of key performance indicators: metrics that help companies define and measure progress toward organizational goals and critical success factors.
You can use KPIs to measure practically any activity your company performs, especially in the financial realm. While a number of common KPIs gauge financial performance, no two companies’ specific KPIs should be the same, because no two companies’ financial goals are the same.
Your Mission Statement
Because KPIs spring from goals and objectives, the first step is to articulate a clear, well-defined mission statement from which your company goals can be drawn. With your mission statement in place and specific goals outlined, you can identify the metrics most critical to achieving these goals.
To be most effective, KPIs should be specific and measurable as well as comparable to some kind of industry benchmark. For example, saying that your goal is to “increase sales” does not help you identify a KPI because you haven’t identified a metric that can be measured. However, a goal of increasing sales by 5 percent this year and 10 percent next year gives you a specific, measurable target to shoot for.
Let’s take one step back, though. Using this example, how do you know that a 5 percent or 10 percent sales increase is necessarily good? This is where benchmarks come in: metrics to which you can compare your KPIs. The most common benchmarks are industry averages and your own company’s performance in prior years.
One of the best places to obtain industry benchmarking data is your industry’s trade group or association. The Risk Management Association provides comprehensive financial statistics broken out by North American Industry Classification System codes in its Annual Statement Studies publication. NAICS is the standard used by federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing, and publishing statistical data related to the U.S. business economy.
Common Financial KPIs
Here are a few of the most common ratios used by business owners:
- Inventory turnover: This tells you how many times inventory turns over, or is sold, during the course of the year. The formula is cost of goods sold divided by inventory. Monitoring your inventory turnover level will help you identify slow-moving items that you should try to move out of your warehouse to make room for more popular ones.
- Debt-to-equity: This measures how much debt your company has in relation to its equity, or your debt capacity. The formula is debt divided by shareholder’s equity. Most lenders want to see a debt-to-equity ratio no higher than 3:1 in potential borrowers.
- Accounts receivable days: This measures how long it takes on average to collect your accounts receivable. The formula is AR multiplied by 365 divided by annual sales. Thirty days is the standard goal set by companies in most industries.
- Accounts payable days: This measures how long it takes you on average to pay your accounts payable. The formula is AP multiplied by 365 divided by cost of goods sold. To conserve cash flow, you should stretch your AP days out as far as you can while still honoring the payment terms offered by your suppliers.
Remember, these ratios and KPIs are of limited value when looked at in isolation. Instead compare them from quarter to quarter or year to year, looking for historical trends that can help you improve financial performance. Also compare them to benchmarks from other companies in your industry to see how you fare against your peers in the most critical areas of financial management for your firm.
Don Sadler is a freelance writer and editor specializing in business and finance.