Fundamental Financial Metrics and KPIsposted on 20-3-17-Tue 13:40
Whether you run a startup enterprise or a successfully established company, your business's success story depends largely on revenue generation and responsible money management. Customers will employ the financial KPI, potentials investors and stockholders to measure the performance and sustainability of your business model. You can as well use them to prove the financial health and success of your business.
Irrespective of the age, size, and industrial sector, every business needs to be aware of how they are performing financially. Although your accountants could handle the income, budget, and expenditure, the company's executives should make it a point of duty to get informed about vital financial figures. Also, the swiftest and most effective method of keeping track of your company's business performance is by creating a KPI dashboard that shows financial metrics.
An ideal financial KPI report gives up-to-date figures pertaining to the company's important financial performance. These data could include Burn Rate, Operating Cash Flow, Current Ratio, debt to equity ratio, etc. and in the course of this article, we will be giving you full insight about some of the essential metrics that most businesses should evaluate.
What are financial KPI's?
A financial Key Performance Indicator (KPI) is a significant figure that shows how good or bad a company is faring in relation to revenue generation and profits. Measuring your KPIs indicate if your business is smashing its long-term goals.
Every financial KPI has a mutual objective, and that is perfecting your business until you record financial success. Nonetheless, they go about it in varying ways. KPIs should have the capacity to track your speed, accuracy, and efficiency in all sections, not minding if they are related to manufacturing, billing, or sales. However, it only does half of the big job; business executives must also learn how to interpret these KPIs. In essence, it is of no good if a manager sees sales figures if he or she does not comprehend what the impacts of those numbers are on the business.
As a financial manager, getting an overview of your company's financial background is principally important for boosting your competitive advantage. Most of the computable KPIs are made available by finances, and this makes them simpler to interpret and act on. Also, you could use financial KPIs to keep track of transaction processes and report them, billing collections, and many more. At this point, utilize the gained insight from the performance indicators to make changes that impact your business positively. The more understanding and proficiency you apply to this process, the better your chances of increasing your competitive advantage.
If you wish to measure the financial health of your company, consider studying the following important key performance indicators for company executives.
Earnings Before Interest and Taxes
This indicator sheds light on a company's profitability. One could say it is the subtraction of expenses from revenue with interest and tax excluded. EBIT could also signify operating profit, operating earning and profit before taxes and interest.
EBIT is calculated by deducting a company's operating expenses (which include costs of manufacturing, employee wages, etc.) from the revenue. This could be done by following the steps below:
- Take revenue or sales from the top of the income statement.
- Deduct the cost of goods sold from sales or revenue, giving you the gross profit.
- Subtract the operating expenses from the gross profit to get the EBIT.
What Does EBIT Indicate?
Earnings before interest and taxes calculate the profit an organization generates from its activities; therefore, it is identical to operating profit. EBIT ignores the expenses on taxes and interests, thereby focusing entirely on the business's revenue generation capacity. It is a useful metric because it aids in identifying the company's ability to make enough money to stay profitable, pay debts, and finance current operations.
EBIT and Taxes
This indicator is useful to investors who are making a comparison between different companies with varying tax conditions. For instance, if a potential investor wishes to buy stocks in a company, EBIT will help to point out the operating profit of the business, excluding taxes. If an organization gets a tax break or a slash in corporate taxes, they will witness an increase in profit and overall net income.
However, the analysis wouldn't take cognizance of the tax cut since EBIT has already eliminated it. EBIT will be more effective if the investor is comparing two companies within the same industry but with tax rates that vary.
EBIT and Debt
While running an analysis for companies within a capital-intensive industry, EBIT could go a long way to help an investor. Most capital-intensive companies have a considerable amount of fixed assets on their balance sheet. Fixed assets are the company's physical properties and are usually financed by debt.
For instance, oil and gas companies are capital intensive because they have to finance their drilling operations on the oil rigs. This results in high-interest expenditure due to the massive debts incurred on the balance sheets. Although, if the debts are appropriately managed, it could help bolster the long-term growth of these companies.
Economic Value Added (EVA)
Economic Value Added (EVA) measures the financial performance of a company as it relates to residual wealth. It is calculated by subtracting the cost of capital from operating profit with tax adjustments on a cash basis. This indicator is also referred to as economic profit because it tries to denote the actual monetary profit of a company. EVA was created by Stern Value Management, a management consulting firm.
Understanding Economic Value Added (EVA)
This is the increasing variation in the return rate over the cost of capital of the company. Basically, it measures the value a company generates from investors' funds. If a company has a positive EVA, it implies that the company is generating value from funds invested in it. On the flip side, if a company has a negative EVA, it shows the company is not producing value with investors' funds.
Components of EVA
There are three components involved in finding out a company's EVA; they include:
- The NOPAT
- The amount of capital invested
- The WACC
The NOPAT can be manually calculated, but it is usually stated in a public company's financials. Capital invested refers to the money used in financing a particular project. The WACC is an investor's expected average rate of return; the figure is obtained as an element of monetary source in an organization's capital structure, and it is also included in the public record.
EVA aims at calculating the cost of investing money into a particular business or project and then evaluates whether it will generate enough profit to be seen as a good investment. The charge signifies the least required return for investors to consider an investment worthwhile. When EVA is positive, it indicates that a project is making returns that exceed the requisite minimum return.
Gross Profit Margin
This is a metric used to evaluate a firm's business model and financial health by showing the left-over funds after the cost of sold goods has been deducted. Also, this indicator is depicted as a sales percentage and can be referred to like the gross margin ratio.
How to Calculate Gross Profit Margin
You can start by calculating the company's gross profit margin percentage. The gross profit is equivalent to subtracting the cost of goods sold from the net sales revenue. Net sales can be obtained by deducting the returns, discounts, and allowances from the gross revenue. After that, divide the gross profit by net sales to obtain the gross profit margin in terms of percentage.
What Does the Gross Profit Margin Indicate?
Analyst characterizes this indicator as to the first profitability level, and it indicates how effective a company is when it relates to providing a service or creating a product compared to its rivals. Gross profit margin permits analysts to make a comparison with business models using a calculable metric.
If the gross margin of a company is inadequate, it cannot fund operating expenses. Generally, the gross profit of a company should be stable unless it has undergone some changes relating to its business model. For instance, if a company opts for full automation, it may increase the initial investment, but the cost of goods sold will be lower due to reduced labor costs.
Changes in industry guidelines or changes in a business's pricing strategy could also impact on gross margin. If an organization sells its goods at a premium, it will have a higher gross margin. However, if the cost is too high, you may record low sales because fewer customers will buy the product.
Net Profit Margin
The net profit margin is equivalent to the amount of net profit or income represented as a revenue percentage. This indicator is usually denoted as a percentage and can also be expressed in decimal form. It shows the percentage of the generated revenue that actually translates to profit. Also, the net profit margin could be referred to as the net margin.
How to Calculate for Net Profit Margin
On the income statement, deducted the cost of goods sold, interest, taxes, operating expenses, and other expenses from the revenue. Then divide the figure obtain with the income. Multiply the figure by 100 to get the percentage result.
What Does Net Profit Margin Indicate?
The factors which affect the net profit margin in every business include total revenue, additional income streams, expenditure, cost of goods sold, debt payment including paid interest, investment income, expenses for unusual events, and other operational expenses.
Net profit margin is a vital indicator of an organization's financial well-being. By keeping track of the highs and lows in its net profit margin, a company can evaluate if its current practices have a positive impact and predict profits based on revenue. Since companies represent their net profit in percentage form, it is easier to compare the profitability between two or more companies irrespective of size.
MRR And ARR
Monthly Recurring Revenue is a financial KPI that indicates the revenue a company expects to make in a month from clients for offering their products and services. In essence, this indicator measures a company's regular monthly revenue. Revenue normalization is important for businesses that offer varying price plans for their goods and services.
MRR gives an average figure for a company's recurring revenue on a monthly basis. It is a common tool employed by Software-as-a-Service companies that create revenue using a subscription-based model. Accounting guidelines such as IFRS or GAAP do not recognize MRR, but investors still monitor it. Analyzing it helps investors to evaluate a company's monthly growth rate quickly. Consequently, most public companies add MRR to their quarterly or annual report if they are operating with the SaaS business model.
Annual Recurring Revenue describes the normalized revenue on an annual basis, which a company anticipates it will get for offering their products and services to customers. Basically, annual recurring revenue is a recurring revenue generated by customers annually. It is also used by businesses running a subscription-based model.
ARR vs. MRR
The ARR metric shares a huge similarity with the MRR. The difference they share lies within the time frame at which they are regularized. Hence, MRR provides a short-term view, whereas ARR is suitable to find out the long-term progress of a company.
ARR is a vital KPI for a company's investors and management. Managers utilized it to measure the general financial health of the company. Additionally, ARR also assesses a company's long-term business plans. From an investor's standpoint, the stability and predictability of ARR make the metric a useful tool for comparing a company's performance against its competitors in addition to evaluating the performance over time.
It is a liquidity ratio that evaluates a company's capacity to pay short-term debts. Investors and analysts use this to find out how a company can optimize its current assets in a bid to clear pending debts and other miscellaneous expenses.
How to Calculate Current Ratio
To calculate this indicator, analysts compare the company's current liabilities with its current assets. Current assets include inventory, cash, accounts receivable, and other assets expected to turn into cash in less than a year. Current liabilities include wages, taxes payable, accounts payable, and the existing fraction of long-term debts.
An acceptable current ratio is one that is on the same level or a bit higher than the industry average. A lower current ratio is a sign of distress or difficulty. The current ratio could also be referred to as the working capital ratio.
Current Ratio and Debt
If a company has a current ratio of less than one, it means that its current capital cannot meet its short-term obligations; however, a company with a current ratio greater than one has the financial resources to handle any short-term obligations. Since the current ratio at a given time is just a summary, it does not totally represent the company's liquidity.
Revenue growth is the growth or decline in a company's sales performance between two periods. Represented as a percentage, this indicator reveals the degree of revenue increase a company has recorded over time.
For instance, if an organization made a $50 million revenue in a fiscal year and records a $75 million revenue in the next economic year, it means the company's revenue grew by 50%. However, if the same company made $50 million in revenue in one year but dropped to $25 million in the following year, then the company witnessed a 50% reduction in revenue growth.
How to Calculate Revenue Growth
The calculation is done by carrying out a comparison between the revenue of the previous period and the revenue of the current period. Every time frame used must have a similar duration. Here, you subtract the previous period revenue from the current period revenue. After that, divide the figure obtained with the previous period revenue to arrive at your answer. This calculation could be done on a monthly, annual, or quarterly basis, and even more. You could evaluate both positive and negative changes in your company's revenue growth.
Things to Consider While Evaluating A Company's Revenue Growth
Carrying out an analysis of your company's revenue growth is not just about finding new ways of generating income or creating new income sources, it is also an avenue to examine the internal processes or sectors responsible for revenue growth. You could also assess the sections that cause revenue devaluation and make long-term projections.
ROI and ROE
Return on Investment measures the performance used in assessing an investment's productivity or the productivity of a collection of investments. This metric directly measures the amount of profit an exact investment will make in relation to its investment costs. In calculating ROI, the cost of the investment is used to divide the return, and the result is shown as a percentage.
Return on Equity is a KPI that is calculated by a division between net income and shareholders' equity. Since shareholders' equity is equivalent to subtracting the company's debts from its assets, ROE could be taken as the return on net assets. It also measures the company's effectiveness in creating profits with its assets.
This metric is denoted as a percentage and is calculated if the equity and net income of a company are positive figures. Before dividends are paid to common shareholders, the net income is calculated, whereas preferred investors and lenders get their dividends after the calculation.
Net income is the net of expense, amount of income, and taxes that an organization generates within a given period. To get the average shareholders' equity, add the equity at the beginning of the period. There should be a coincidence between the beginning and end of the period and the period in which the net income is made.
Net income for a fiscal year is shown in the income statement; it is a sum total of financial activities within that period. Also, the shareholders' equity is shown on the balance sheet.
Generally speaking, there are tons of financial KPIs out there; however, you may not need to use all. Most times, their usage is dependent on your needs. Also, it is important to set goals first. You can track the goals effectively with as many KPIs as you want.
What are financial KPI?
Financial KPI (Key Performance Indicator) is a calculable value which shows how well an organization is faring with regards to generating revenue and profits. Keeping an eye on KPIs will indicate if a business is smashing its long-term goals.
Why is KPI important?
KPIs are important because they help businesses to keep their objectives on the front burner while making a decision. It is important that business objectives are known by everyone within an organization. When employees and stakeholders know and are in charge of their own KPIs, it keeps the company's goals on everyone's mind.
How do banks measure financial performance?
Earnings are used to measure the bank's ability to cover loan losses, increase capital, and grow the loan book through normal operations. Liquidity measures the lifeblood of the bank.
What is the difference between KPIs and objectives?
KPIs are performance measurements employed in defining the progress and success factors of a business objective. On the other hand, objectives are abridged statements that describe specific actions a company must take to execute its strategy
What are the benefits of KPIs?
KPI are measures that indicate how well your business is doing in terms of sales, customer satisfaction, profit, cost control, return on investments, and human resource management.
What are the key financial indicators?
- Growth – Checks if your sales and profits are growing or declining over time.
- Profitability – Checks if you are making enough profit compared to your competitors
- Liquidity – How well can your business meet its short-term obligations?
What is meant by financial performance?
Financial performance individually measures how effectively a company uses its primary assets to generate revenue. It is also used to evaluate the overall financial well-being over a given period. Investors and analysts use this tool to compare industries or sectors and to compare companies within the same industry.
How to measure financial performance?
There are various methods for measuring financial performance. Line items like revenue operations, cash flow from operations, operating income, and total sales unit can be used. Moreover, an investor and analyst might want to take a deep dive into the financial statement to find out growth margins or any declining debt.
A company is made of many stakeholders: the investors, employees, bondholders, trade creditors, and management. Each group keeps its own interest in mind while tracking the company's financial performance. Analysts discover more about the company's financial performance from data released in the annual report. The report serves the purpose of providing stakeholders with reliable and accurate information that offers an insight into the organization's financial performance.
Additionally, company executives review and sign this report together with other disclosure documents. This makes the annual report the most understandable information piece accessible to investors annually. The financial statement also includes the income statement, the balance sheet, and the cash flow statement.