Top 3 Financial KPIs Every Business Owner Should Track
January 26, 2023
Every business needs to keep track of its finances – whether a budding startup or a massive corporation. It is the only way business owners can effectively plan and protect their bottom line. How exactly do you keep track of an organization's financial performance?
The answer lies in using financial key performance indicators (KPIs). They illustrate your business's financial health and help you evaluate whether your business will turn a profit. Think of these financial KPIs as measurable metrics that determine your company's growth, revenue, and earnings performance.
Below, we take a comprehensive look at the top three financial KPIs every business owner needs to track. Read on to ensure your company's financial performance aligns with your goals.
GROSS PROFIT MARGIN
The main objective of a business is to generate profit. Having revenue without profit means nothing for your business. Therefore, the gross profit margin is among the top financial KPIs you need to consider.
What Is It
The gross profit margin percentage is the percentage of revenue that is considered profit after factoring in the costs of goods sold. The formula for calculating gross profit margin percentage is:
(Revenue – the Cost of Goods Sold) ÷ Revenue = Gross Profit Margin Percentage
All direct expenses associated with the product are considered the cost of goods sold. This number does not include taxes, interest payments, or operating expenses.
For instance, let's say your business earned $500,000 in total revenue for the year-end. Your direct costs for that year were $200,000. Therefore, your gross profit margin percentage would be as follows:
($500,000 - $200,000) ÷ $500,000 = 60%
What Should it Be?
The gross profit margin must comfortably pay for the operating (fixed) expenses. It should also have enough left over to serve as profit. These extra earnings drive your company by paying for fixed costs, marketing campaigns, dividends, and more.
A lower number means your business is running on fumes and will be unsustainable at some point. However, the exact margins will also differ between industries.
Are you looking to fund a new project or make a large purchase? How do you know whether your business can afford it? The current ratio is the KPI you need to measure. Tracking this indicator is the ideal way of knowing whether your business is experiencing cash flow problems.
What is It
Also referred to as the working capital ratio, the current ratio measures your liquidity. It is a key performance indicator that determines the amount your business has as cash on hand for large purchases. Often, creditors will use this ratio to determine your capability of repaying a particular loan.
The formula for calculating the current ratio is as follows:
Current Assets ÷ Current Liabilities = Current Ratio
Your business's current assets include cash and any other assets you plan to convert to cash in less than one year. On the other hand, the current liabilities are debts that need to be paid off within one year.
However, you can always use the working capital formula to know the amount of liquidity you have. It gives you the amount rather than a ratio, which is ideal when you are looking to make a significant purchase. The formula for calculating working capital is as follows:
Current assets – Current liabilities = Working capital
What Should it Be?
Your ideal current ratio needs to fall somewhere between 1.5 % and 3%. Having less than 1% is a red flag because your business lacks enough cash to pay incoming bills.
Often considered the most important financial KPI, the debt-to-equity ratio measures the degree to which your business is financing operations with debt instead of its resources. It shows how much debt you have for every dollar of equity. Your financial department can, therefore, use it to understand how and where to invest back into the business and maximize profitability.
The formula for calculating the debt-to-equity ratio is as follows:
Total Liabilities ÷ Total Shareholders' Equity = Debt-to-Equity Ratio
A lower debt-to-equity ratio is crucial when applying for a business loan. It is among the primary numbers a lender will look at before granting a loan. A higher number means a higher risk, while a lower number indicates a lower risk.
What Should it Be?
Although the optimal debt-to-equity ratio will vary depending on the industry, it should not exceed 2.0. A company with a debt-to-equity ratio of 2.0 borrows twice as much as it owns – two debt units per equity unit. New businesses tend to have a high ratio because they depend on debt to fuel growth.
THE BOTTOM LINE
Every industry is getting more and more competitive. Therefore, it is important for business owners to keep track of the above financial KPIs. Doing this ensures you stay on top of your finances and make smart, data-driven decisions to protect your bottom line.
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