Small businesses face various challenges, with most of them affecting their finances. Unlike medium and large businesses, small businesses are very vulnerable to the effects of poor decision-making and inept financial management. Poor decisions arise when managers or decision-makers use outdated, irrelevant, or inaccurate financial data that relies on estimations and assumptions.

Small businesses should design and implement an organized financial structure that aligns with company goals and objectives to accurately estimate business performance. This can be achieved only by using tools that track business performance, specifically financial health. Finance KPIs (key performance indicators) are among the many tools that provide a quick evaluation of a business’s financial health.

What Are Financial KPIs?

Financial key performance indicators are specific metrics that businesses can use to track or monitor their financial health. These metrics measure your business performance against various financial goals, such as profits and revenue. As such, you can use them to compare the financial well-being of your small business against various internal benchmarks and competitors.

Small businesses should consider financial KPIs when making strategic plans. Businesses can use them to determine the best times for investment. As such, monitoring these KPIs is important for long-term business success.

What Are Key Financial KPIs to Focus On?

Small businesses should keep tabs on the following key financial metrics;

1. Gross Profit Margin

The gross profit margin is the percentage of profits from the total income revenue. To find this value, you should deduct the cost of goods and other expenses, such as the cost of production. Shown as a percentage, you can calculate the gross profit margin of your business as follows;

Gross profit margin = (Revenue – total cost of goods sold) ÷ Revenue

As mentioned, the cost of goods sold includes all direct expenses associated with products. It doesn’t include other expenses, such as taxes, payment for interests, and operating expenses. If you earn $1 million as revenue for the year ending and the direct costs of production are $400,000, your gross profit margin would be;

(1,000,000 – 400,000) ÷ 1,000,000, which is 60%.

For businesses making profits, the gross profit margin should be large to cover fixed expenses, and the surplus remains as profits. You can use the extra amount to fund your marketing campaigns, pay dividends, and other costs.

Your gross profit margin should be at least 10%. Anything less than this should be a cause for concern. However, remember that gross profit margins vary depending on your business model and industry. For instance, construction firms and engineering businesses may have gross profit margins of 12%. On the other hand, banks have more than 90% margins.

2. Net Profit

Your net profit is the amount of money left after you have paid all your business bills. Also called net income, net profit encompasses direct and indirect business expenses, which is an important factor when calculating operating cash flow. To calculate net profit;

Net profit = Total revenue – Total expenses

For instance, if your annual sales total to an estimated $200,000 and your business rent, inventory, employee salaries, and other expenses add up to $120,000, your net profit for the year is $80,000. Unlike gross profit margin, no exact amount is considered “healthy” profit. However, as a rule, you should ensure that your business is making profits.

3. Net Profit Margin

The net profit margin informs businesses what percentage of the revenue was profit. Unlike the gross profit margin, the net profit margin includes direct costs and all business expenses. The formula for calculating net profit margin is as follows:

Net Profit Margin = (Total Revenue – Total Expenses) ÷ Total Revenue

Using the example above, suppose your revenue is $1,000,000, the direct costs were $400,000, and non-operating expenses of $200,000, your net profit margin will be as follows;

($1,000,000 – $600,000) ÷ $1,000,000, which is 40%.

Calculating the net profit margin helps in predicting future profits. For instance, based on the example above, the net profit margin is much lower than the gross profit margin in example one. However, the only addition to the calculation is the non-operating expenses. To increase your profit margin, you should find ways of reducing the non-essential expenses.

4. Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio estimates the effectiveness of cash collection from credit sales made. The formula for calculating this ratio is as follows;

AR turnover ratio = Net credit sales ÷ Average accounts

Remember to exclude any returned items when calculating your net credit sales. Similarly, to determine the average accounts, add your beginning balance to the ending balance, then divide by two. A high accounts receivable turnover ratio is better as it shows that your credit customers are paying faster.

5. Current Ratio

The current ratio is among the important KPIs and metrics for finance departments that measure business liquidity. You should use this metric to determine if you have sufficient cash to fund large purchases. Creditors also use this metric to determine a business’ likelihood of repaying loans. The current ratio is calculated as follows;

Current ratio = Current assets – Current liabilities

Current assets are anything, including cash and business assets, which can be converted into cash quickly. On the other hand, liabilities are debts or credits that should be repaid within the year. A healthy business should have a current ratio ranging between 1.5% and 3%.

You should be concerned if your current ratio is below 1%, as it means you don’t have enough cash to pay your bills. Tracking this metric provides a good warning of impending cash flow challenges.

6. Quick Ratio

The quick ratio is another relevant key performance indicator used to monitor business financial health. This metric is closely related to the current ratio, as it evaluates a business’ immediate ability to pay short-term liabilities. However, the quick ratio is better than the current ratio because it only shows the business’s likelihood of paying its liabilities within a fiscal year.

Quick ratio = (Current assets – Inventories) ÷ Current liabilities

Most people refer to the quick ratio as an acid test ratio. This is because acid tests produce quick results, just like the quick ratio.

7. Customer Acquisition Ratio

Calculating the revenue received from every new customer is another effective way of measuring your business’s financial health. Calculating the customer acquisition ratio is very easy.

Customer acquisition ratio = Net expected lifetime profit of a customer ÷ cost to acquire the customer

The main challenge is determining the net expected lifetime profit of the customer. However, you can do this by monitoring the customers’ average purchasing price and purchase frequency. On the other hand, customer acquisition costs include marketing and onboarding expenses. These variables vary from one business to another.

A less than 1% customer acquisition ratio means that you are spending too much on customer acquisition who aren’t spending much on your business. A corresponding high ratio shows that your customer acquisition efforts are worthwhile.

8. Return on Equity

Return on equity is another important metric, especially for businesses with shareholders. The formula and method for calculating return on equity is as follows;

Return on equity = Net income ÷ Shareholder equity

This metric shows how your business has garnered profits from shareholder investments. Note that shareholders represent the total assets minus business liabilities, and it shows the profits made from shareholder investment in your business.

Which Metric Should You Use?

While all the KPIs mentioned above are important business financial metrics, which one should you use in your business? Good and effective metrics should be measurable and directly relate to your strategic goals. Unfortunately, not all metrics are the same. Besides, your business needs to vary from those of other businesses.

For instance, brick-and-mortar businesses won’t focus on customer acquisition ratios. Similarly, an ecommerce store won’t monitor the sales per square foot. You should evaluate your business and business processes when choosing financial KPIs. For instance, if you currently don’t have deliverable products, you shouldn’t worry about some KPIs, such as the cost per acquisition ratio. Instead, focus on relevant KPIs to streamline your decision-making.

Additionally, you should ensure that your financial performance metrics indicate both leading and lagging indicators. Lagging indicators are things that have happened before, such as total sales of previous months or individual employee income. On the other hand, leading indicators are metrics that monitor inputs and contribute to achieving strategic business goals. A good example of a leading indicator is the conversion rate.

Consider the following questions to determine the best KPIs for your business;

• What are your ultimate goals?
• Why are these goals relevant?
• Which objective information do you use to define success or failure?
• What variables determine the outcome of your goals?
• How will you know if you have achieved set goals?
• Is there a timeframe for measuring these goals?

For instance, if you notice that your annual revenues have dropped, you should track sales metrics to improve annual income. You should include “sales growth” on your business’ KPI dashboard with the goal of increasing revenue by 20% within six months.

Endnote

As you choose suitable financial KPIs to monitor your business financial health, ensure that your chosen metrics are measurable and provide accurate insights. As mentioned, one metric may be relevant to your business and irrelevant to another due to varying business needs. It is important that you use relevant KPIs depending on your specific business needs.

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