It has often been said that you can’t manage what you can’t measure. In sports, success is measured by the score. In business, there are a number of measurements that can be tracked and monitored to help management gauge the performance of the business. These metrics are commonly referred to as Key Performance Indicators or KPIs.
One of the many responsibilities of a CFO is to develop KPIs applicable to the business, support the analysis of those KPIs on a regular basis, and make changes that directly improve KPIs to help improve the future value of the company.
The Importance of KPIs to Business Success
Businesses are multi-faceted and therefore it is important for a company to monitor a number of different KPIs that each provide some insight into business performance. Some of these measurements may be more basic, such as days sales outstanding or inventory turnover, while others can be a bit more involved, such as employee utilization or profitability by individual client/product line.
Once KPIs are defined, it is important to understand the ways in which those measurements can be used to enhance the performance of the business. As an example, JPMorgan Chase & Co was able to reduce their fully burdened labor costs by $3.2 million annually by eliminating voice mail for consumer-bank employees. One of our brewery clients was able to increase profits by 15% after adjusting their pricing and distribution strategies following a detailed analysis of their profit margins by individual product line.
Knowing what to measure and then making operational changes to directly influence those measurements can have a significant impact on the bottom line.
KPIs will be different for every business; however, below are some basic KPI examples, how to calculate them, what they measure, and the best way to use the measurement to improve profitability.
Days Sales Outstanding
(Accounts Receivable) / (Sales on Credit or Terms) x (Number of Days the Sales Represent)
This KPI measures how many days of sales are in accounts receivable. Hopefully this measurement will be at (or near) what your credit terms are. For example, if you have credit terms of 45 days, your days sales outstanding should be close to that. This KPI can be impacted by offering a slight discount for early payment to reduce outstanding accounts receivable.
(Cost of Goods Sold) / (Average Inventory) x (12 Months)
This KPI measures the number of times the inventory is sold–or the turnover–in one year. An inventory turn of 1 would mean you sell all your inventory once a year, whereas an inventory turn of 12 would indicate you sell your inventory every month. This KPI is influenced by reducing slow moving or excess inventory, or by increasing sales which will in turn increase cash flow.
Days Sales in Inventory
(Average Inventory) / (Cost of Goods Sold) x (Number of Days)
This KPI measures how many days of inventory is on-hand. It is similar to inventory turnover, but indicates the number of days until inventory is sold. For example, if the days sales in inventory is 30 days, then the inventory turns would be 12 (or once a month). You can affect this KPI by carrying the least amount of inventory necessary to meet demand.
(Current Assets) – (Current Liabilities)
This KPI measures the excess (hopefully) of liquid assets to meet long term needs. It can be affected by increasing cash flow through sales and net income.
Return on Assets
Net Income) / (Total Assets)
This KPI measures the rate of earnings generated from invested capital in assets and can be affected by increasing earnings and/or reducing invested capital.
Return on Equity
(Net Income) / (Shareholder’s Equity)
This KPI measures the return on capital invested by shareholders of the company and can be affected by increasing earnings and/or reducing the amount invested by shareholders.
What KPIs Should You Measure?
KPIs for capital-intensive industries (e.g., manufacturing, distribution, etc.) tend to focus on how effective and efficiently assets are utilized to produce a return. Whereas KPIs for service-based organizations (i.e., companies that bill people, hours or projects to clients) tend to focus on utilization (percentage of total working time charged to customers) to drive profitability.
Most businesses, regardless of the industry, should measure KPIs that focus on generating positive cash flow from operations. Companies should also monitor how quickly it can turn sales into cash (days sales outstanding) or how long money is invested in inventory (days sales in inventory).
The important thing is to determine what measurements are most appropriate for your specific business and industry. One way to do that is to look at other companies in the same industry and identify what measurements they are using. Those measurements can also be used as benchmarks to compare your business against others in the same industry.
We Can Help
Profitability is the easiest and most straightforward measurement of a company’s success; however, if you really want to take your business to that next level, it is also important to look at other key performance indicators that can drive profitability and how they can be influenced to increase and drive performance. If you need help identifying, monitoring and influencing KPIs to improve the current and future value of your business, contact us today for a free consultation.
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