How to Use KPIs to Improve Financial Health
Key performance indicators (KPIs) can help you improve your financial health through strategic monitoring of metrics that help you understand the underlying stability of your business.
Let’s dive in!
What are KPIs and How Can They Improve Financial Health?
KPIs help you monitor an intended result. We discuss this in full detail in our guide on KPIs, but a quick summary is:
- KPIs help you track progress
- Various KPIs are important for business progression
- KPIs are not one-size-fits-all
Monitoring your business’s progression with KPIs empowers business leaders to make strategic adjustments to improve the financial health of their companies. If you don’t monitor KPIs over time, you’re likely missing out on benefits that promote profitability and long-term success.
5 Financial KPIs You Should Be Tracking
1. Gross Profit Margin
Profit margins are a representation of your core profitability after you account for the cost of goods sold (COGS). For example, you’ll use the formula of (Net Sales – COGS) / Net Sales. If you sell software for $100 and the COGS is $85, your profit margins are (100/85) / 100 = 0.15%.
Of course, you always want this percentage to be higher than 0.00%, and if COGS grows, it can even turn negative, meaning you’re in the red.
What’s a healthy gross profit margin?
It depends on the business and industry. Retailers can make 35% – 65% gross profit margins, but you may have much higher or lower percentages than this figure. Over time, review this figure and adjust pricing to maintain healthy profits.
2. Net Profit Margin
You have your gross profit margins, but net profits help you make critical decisions. If you want your total profits after accounting for all of your business expenses, you’ll use this formula: (Net Income / Revenue) * 100%.
Let’s assume that you had $2 million in revenue and $500,000 in net income.
You would do the following: $500,000 / $2,000,000 = 0.25 * 100 = 25% net profit margins.
For many companies, net profit margins of 25% are unheard of and would be exceptionally higher than the average.
A few industries and their respective net profit margins are:
- Grocery store – 2.4%
- Banks – 24.6%
- Insurance brokers – 5.6%
If you’re able to determine your net profit margins and monitor them, you’ll have a much easier time staying within your business budget.
3. Operating Cash Flow Ratio
QuickBooks reports that 61% of small businesses go under in five years because of cash flow problems. Monitoring your operating cash flow ratio (OCF) helps you better understand your business’s ability to pay off short-term liabilities with cash from operations.
You’ll use the following to determine your ratio: Operating cash flow / current liabilities.
4. Sales Growth Rate
Sales growth rates are one of the most important KPIs you can monitor and one that I believe every company should already be monitoring. If you have a positive sales growth rate, you’re making more sales today than you did during your prior period’s sales.
For this formula, you’ll need: (Current net sales – prior period net sales) / prior period net sales * 100.
Let’s assume that you have $1 million in current sales and $800,000 in prior period sales. Your growth rate would be (1,000,000 – 800,000) / 800,000 * 100 = 25% sales growth rate.
If you see this rate falling, reconsider your marketing strategies and current market trends. You may need to introduce new products or services to keep sales rates at a healthy level.
5. Days Sales Outstanding (DSO)
DSO is a measure of how fast customers pay you. If your customers are waiting for 30, 60 or 90 days to pay, it reduces your ability to make strategic growth decisions. For example, if you had the cash in the bank, you could use it to take on larger projects or buy more inventory to sell.
With this in mind, your DSO formula would be: (accounts receivables / net credit sales) * number of days.
If you have a DSO of 40 – 45, that’s generally considered good in many industries, but the DSO will vary greatly depending on your industry, too.
At Redmond Accounting, we encourage billing up front so you never have any accounts receivable.
KPIs are a powerful tool that every business can use to measure objectives, make strategic improvements and understand how the business’s underlying financials are performing. Over time, you’ll learn to rely on key performance indicators to make data-backed decisions that help your company grow.
Schedule a consultation to learn how we can help your business improve financial health by integrating KPIs into your day-to-day operations.
