- Finance and Accounting: The Why and What
- Financial Statements: Structures and Relationship
- Understanding Balance Sheets
- Understanding Income Statements
- Understanding Cash Flow Statement
- The Significance of Cash Flow
- Key Performance Indicators of a Business
- Cost Accounting
- Plan your Business
- Three Finance Concepts Every Manager Should Know
- Building a Marketing Budget
Key Performance Indicators of a Business
A company’s numbers can be analysed and help assess its performance from more than one dimension. When compared against a benchmark it can be seen if a company is doing well or not.
These performance metrics help measure:
- Financial Status and Net Worth
- Financial Leverage
The measure of Financial Condition and Net Worth include current ratio, quick ratio, day sales outstanding (dso) and Inventory turnover.
Current Ratio =(Current Assets) ÷ (Current Liabilities)
This ratio where current assets are divided by current liabilities, help assess the liquidity of the company. This helps assess it’s ability to generate cash for operations. Current assets are cash or cash like debtors who will pay in the next 12 months. Likewise current liabilities are debts that must be paid within the next 12 months. Current assets include accounts receivable and inventory. Eventually some of these will become bad debts and some of it dead stock. So current assets must be more than equal of the current liabilities. Banks like to see a ratio of 2:1 or more. Industry standards vary. This ratio reflects the company’s cash reservoir to clear its liabilities.
This ratio sees current assets after inventory is removed. This is more liquid current assets.
Quick Ratio = (Current Assets-Inventory) ÷ (Current Liabilities).
In the case of firms with large inventories, banks and investors seek out the quick ratio. In a company with a 2:1 current ratio, a 1.4:1 quick ratio is adequate.
Day Sales Outstanding
The day sales outstanding are the number of days of average sales yet uncollected in accounts receivable.
Day Sales Outstanding = (Accounts Receivable) ÷ (Average Revenue per Day)
This number tells us how much the company adheres to it’s collection terms .A company with a 30 day credit period does not ideally get it in this time frame. A 40-50 day range is normal.
A quicker turnaround of inventory indicates a lower chance of dead stock piling up. High turnover in inventory means how quickly inventory is leaving the plant and being replaced.
Inventory Turnover =(Annual Cost of Gods Sold)÷ (Average Inventory)
Measures of Profitability include Gross Profit Margin ,Net Profit Margin and Cost per Sales Dollar.
Gross Profit Margin
Gross Profit Margin = (Gross Profit) ÷ (Gross Sales)
Gross profit margin measures gross profit as a percentage of gross revenue. This helps capture profit as a percentage of revenue, and helps assess components that affect profitability.
Net Profit Margin
Net Profit Margin = (Net Profit) ÷ (Gross Sales)
When net profit or the bottom line, profit after subtracting all costs is shown as a percentage of gross sales we call it net profit margin. This margin varies from industry to industry. For example a 5-6% profit in the steel manufacturing industry is considered very good,but poor for the pharmaceutical industry. It also needs to be considered with that firm’s historical performance.
Cost per Sales Dollar
Cost per Sales Dollar = (Sales and Marketing costs) ÷ (Gross Sales)
This helps estimate sales and marketing as a percentage of Gross Sales. This helps in cost control.
Financial Leverage Measures include debt to equity ratio, Interest coverage and return on equity.
Debt to Equity Ratio
Debt to Equity Ratio = (Total debt) ÷ (Total Equity)
This ratio shows the extent the company is leveraged. If the company has too much debt, any dip in business may result in the owner losing it’s equity or put the company in a position wherein itcannot serviceits debt.Alternatively, if the debt quotient is small, it probably means the company is not putting enough capital to work.
Factors that effect this ratio are:
- Additional working capital can be put to use to increase profits
- Component of debt if it is short term or long term.This will determine the payback period.
- Interest rate of the debt. Short term creditor debt is low compared to long term debt.
- Level of profitability in the industry. A low margin industry cannot afford high cost debt, unlike a high profit margin industry.
Interest Coverage = (EBITDA) ÷ (Interest Expense)
This performance indicator is used by banks to measure a company’s ability to pay the interest of the debt taken from it.
Return on Equity
Return on Equity = (Net Income –annualized) ÷ (Stockholders Equity)
This ratio measures the rate of return on the stockholders cumulative investment in the company.
This is a measure of a company’s earning power.It is often used while selecting stocks.
Price Earnings Ratio or PE ratio
PE = (Stock Price) ÷(Earning).
This is a critical ratio of the stock’s price performance. This ratio is usually measured against a benchmark. It gives you quick information about the company’s earning, without reading a detailed income report.
To assess if resources are being used adequately, we look at measures of productivity.
Backlog of firm orders
Backlog of orders = all firm orders received-all orders shipped and invoiced
If the backlog reduces overtime, it shows sales is unable to bring in new orders. This might be due to a recession or poor execution of past orders. In the converse situation where backlog is more, this due to orders rushing in or an inadequate completion of orders.
In a good organisation backlog is considered a result of good sales and marketing.
Order Processing Time
It is important to assess average time to process an order.If the turnaround time is very long,the company will lose customers. Shorter process times indicate better utilisation of resources and better customer satisfaction levels. This will translate into newer orders.
Sales per Employee
The sales per employee helps measure the productivity of the sales force. It also helps in deciding if a new employee is to be taken on board, or the existing ones suffice.
Sales per customer
In cases where costs of producing are fixedprofits can be increased by increasing average buy per user.
So we see how all these indicators assess use of resources in different areas of an organisation. They are quick and useful ratios in tracking its well-being.