A Crash Course On KPIs

Features - Finance & Accounting

More than a dozen valuable tools to help you more effectively track and monitor the performance of your snow and ice management operation.

©Michail Petrov | adobe stock

To measure business performance accurately, a company must design, build, and follow an organized financial structure which goes hand in hand with their company goals, objectives, and the overall organizational culture. This is done by employing tools that objectively track your company’s performance and its financial health.

Key Performance Indicators (KPIs) serve as quick measures to check the financial health of a business accurately while tracking objectives and milestones. Make sure the key ingredient for effective financial performance has been set up to avoid problems in the future when relying on using KPIs for effective decision making.

What Are KPIs?

Key performance indicators are quantifiable measures that are developed to evaluate the success of a company, a project or a milestone when trying to accomplish a set goal. Different types of KPIs are used by businesses to measure and evaluate the level of performance in different areas of their company, ranging from administration, supply chain management, human resource, and finance.

Net profit. Net profit defines your net financial progress, it is the funds left after all of the expenses have been deducted from the total income. Expenses incurred are of two types – indirect expenses and direct expenses.

Net profit = Total revenue- Total expenses

For instance, if your sales amounted to $20,000 and your expenses – which include your bills, employee salaries, etc. – amount to $12,000, then your net profit is $8,000. Remember, your business revenues and expenses should always lead to net profits for positive business health instead of net losses. There are certain businesses which might not have net profits – such as not-for-profit organizations or research and development businesses. However, there are other KPIs to measure their performance.

Net Profit Margin. The percentage of profits earned after deducting your business expenses, both operating and non-operating, from your business revenues is your net profit margin. Net profit margin considers all the expenses incurred, unlike gross profit margin which only considers direct expenses.

Net profit margin = (total revenue- total expenses) / total revenue

For instance, your business earned a solid $100,000 revenue, but your expenses are projected to be around $70,000. Your net profit margin will be 30% :

Net margins may vary from industry to industry, but it’s important to note these figures provide insight into your potential profits in the future and also help you devise policies that allow cutting non-value adding costs to improve the overall margin.

Gross Profit Margin. The percentage of profits earned after the cost of goods which have been sold are deducted from the total business revenue. Cost of goods, in this case, can also be the expenses incurred while selling a service.

Gross profit margin = (revenue-cost of goods sold) / revenue

For instance, if you earn $200,000 in revenues and the cost of goods sold is $120,000, then your gross profit margin will be 40%

It’s very important that your Cost of Goods Sold (COGS) do not exceed your total revenue. You should have sufficient gross profit to cover your operating expenses (fixed costs), and additional savings on top that can be reinvested in other areas of your business.

Remember, a sustainable business’s gross profit margin should be more than or equal to 10%. Margins lower than 10% should be a warning. And like net profit margins, gross profit margins may vary from industry to industry.

Current Ratio. The current ratio as a key performance indicator is important for not only your business, but also your creditors. For businesses, it provides an estimate of your liquidity, that is to check whether you have sufficient cash in hand to sponsor a large purchase or project. For creditors, the liquidity aspect of this KPI helps determine the probability of your business repaying a loan.

Current ratio = Current assets/Current liabilities

The current ratio of your current assets to your current liabilities should fall between the range of 1.5 and 3. A less-than-1 current ratio depicts the shortage of cash to pay your business bills. This indicator also helps you track your cash flow problems early on.

Customer Acquisition Ratio. The customer acquisition ratio is another KPI that determines how much revenue you earn per each new customer acquired. To understand the customer acquisition ratio, you must focus on two key terms. First is the net expected lifetime profit from a customer, which is determined by estimating the number of times a customer makes purchases and the average purchasing price.

The second is the cost to acquire a new customer, which takes into account the expenses incurred on marketing and advertising. These figures will vary from company to company.

Customer acquisition ratio = net expected lifetime profit from a customer/cost to acquire a customer

For instance, if your customer acquisition ratio results in 5, it means that you are earning $5 for every $1 spent on acquiring a new customer. Remember, if this ratio exceeds 1, than you do not need to worry about your customer acquisition strategy. However, if it falls below one, then your spending on customer acquisition is only resulting in losses. A ratio of higher than 1 indicates your investment is paying off well.

Quick Ratio. The quick ratio holds significant importance in determining a company’s financial capacity to meet all of its short-term liabilities.

Quick ratio = (current assets – inventory) ÷ current liabilities

While the current ratio shows the probability of a company fulfilling its financial liabilities within a time period of a year, quick ratio is a better measure to investigate the company’s liquidity to meet its financial debts by providing quick and relevant results. It may also be referred to as the “Acid Test Ratio” in some instances.

Inventory Turnover. This is one of the many financial metrics used for the purpose of checking the financial health of a business regardless of the company’s size. Inventory turnover represents the frequency of inventory sold and replaced within a year’s time. Inventory turnover can be determined by using these two equations:

Inventory turnover = Sales/Inventory

©wladimir1804 | adobe stock

Inventory turnover = Cost of goods sold/Average inventory

If the inventory turnover turns out to be low, then it means a company has a surplus of inventory at its year-end and its ability to generate sales is poor. However, a high inventory turnover rate indicates the business is maintaining a profitable balance.

Return On Investment. Return On Investment (ROI) determines the effectiveness of an investment or to compare multiple investments made by the company. ROI measures the return generated on a particular investment compared to the investment made. In order to calculate ROI accurately, the return generated by an investment needs to be divided by the cost of the investment. The result is either a percentage or a ratio.

ROI = (Present Value of Investment – Investment Cost)/Investment Cost

Customer Acquisition Cost. Customer Acquisition Cost (CAC) is the average amount of money spent on sales, marketing, and related expenses to acquire a new customer. This reflects the efficiency of your marketing efforts, although it’s much more meaningful when combined with some of the other metrics and when compared to competitors’ CAC.

Customer Retention Rate. Acquiring new clients is important, but retaining them is critical. Your Customer Retention Rate (CRR) indicates the percentage of paying clients who remain paying customers during a given period. The converse to retention rate is churn (or attrition), the percentage of customers you lose in a given period of time. When we see high retention rates over an indicative time period, we know the company has a sticky product or service and it is keeping its customers happy. This is also an indicator of capital efficiency.

Lifetime Value. Lifetime Value (LTV) is the measurement of the net value of an average customer to your business over the estimated life of the relationship with your company. Understanding this number, especially in its relation to CAC, is critical to building a sustainable company.

We consider the ratio of CAC to LTV to be the golden metric. This is a true indicator of the sustainability of a company. If a company can predictably and repeatedly turn x into 10x (note: 10x is just an illustration and not meant to imply any sort of minimum or standard), then it’s sustainable.

The most successful founders tend to be those who have an obsessive focus on their KPIs and the drive to constantly experiment and optimize them.

Monthly Burn. This is simply the net amount of cash flow for a month when net cash flow is negative. For example, if the company starts the month with $100,000 in cash and ends the month with $90,000 in cash, its burn rate is $10,000. If a company’s monthly net cash flow is positive, it is not burning cash.

Runway. Runway is the measure of the amount of time until the company runs out of cash, expressed in terms of months. Runway is computed by dividing remaining cash by monthly burn. We prefer to view a conservative estimate of runway that calculates the monthly burn utilizing current revenue and projected expenses (after accounting for the increased expenses to be incurred post-investment). We require an absolute minimum of 12 months of runway but have a strong preference for 18 months or more. Short runways cause entrepreneurs to by myopic and not to have the liberty to tweak and iterate when necessary. It also forces them to almost immediately focus on the next fund-raising round instead of growing the company.

CAC Recovery Time. Also known as Months To Recover CAC, this KPI measures how long it takes for a customer to generate enough net revenue to cover the CAC. CAC recovery time has a direct impact on cash flow and, consequentially, runway.

Whereas CAC measures the variable expenses attributable to acquiring customers, overhead measures the company’s fixed expenses incurred irrespective of the number of customers acquired. Overhead relative to revenue is a reflection of the capital efficiency of a company. All things being equal, though, a company that generates $1 million in revenue on $200,000 in overhead is twice as efficient as one that generates $1 million in revenue on $400,000 in overhead.

A frequent Snow Magazine contributor, Fredric R. Haskett CA, CTP, LICM, is a business coach and co-founder of TrueWinds Consulting. An industry educator and speaker, Fred often writes articles about a wide variety of management issues, including planning, training, recruiting, and sales and marketing. You can reach him at fred@truewindsconsulting.com