Key Performance Indicators (KPIs) measure value that can demonstrate how effectively a company is achieving key business objectives. Typically, KPIs are values that help business owners understand their company and how well it is achieving its business objectives. KPIs are initially established by the finance team, which develops KPIs to match the company’s needs. Different industries require various growth measurements that are specific to the respective industry. Constantly reviewing KPIs will help financial executives and business owners spot potential problems before they become serious. Additionally, KPIs help determine the condition and sustainability of your current business model and provide a full view of your company’s financial landscape increasing the company’s competitive advantage.
In Part 1 of this 2-part blog I’ll explore how financial executives, including those who are acting in an outsourced capacity, can provide important and timely advice to owners and executive managers. KPIs have been shown to be of particular value to the leadership of many firms. One reason is that it is often the financial executives who identify the most critical issues early on, and who then use the data from KPIs to raise red flags and create the opportunity with business owners to take the require steps to address perceived weaknesses. Business leaders also must learn how to read KPIs effectively and understand the impact that those numbers have on the overall business.
Let’s take a look at two KPIs, which can help identify potential issues at the management level:
- Working Capital:
Formula: Current assets less current liabilities
Working Capital identifies how prepared the company is to meet short-term financial commitments. Working Capital is calculated by subtracting current assets from current liabilities and creates a picture of your business’s financial health and stability by evaluating available assets that meet short-term financial liabilities. A CFO can use this Working Capital number to determine various solutions for the short-term liquidity issues. For example, positive Working Capital shows creditors and investors that the company can generate enough from operations to pay for its current obligations with its current assets and can expand without taking on new debt or new investors. Negative Working Capital shows management that the obligations are not supported with the current assets and would likely require taking on new debt or investors to continue operations. Some of the ways a CFO might be able to improve the liquidity and positively impact Working Capital is by decreasing the accounts receivable collection time and negotiating terms with vendors.
- Current Ratio:
Formula: Current Assets divided by Current Liabilities
The current ratio measures liquidity and helps identify the company’s ability to pay its financial liabilities and obligations, often within the next twelve months. The ratio also weighs your assets against your current liabilities to help you understand the solvency of your business. Typically, the goal is to maintain a ratio greater than 1. A ratio lower than 1 typically indicates the inability for the company to pay off its obligations if they were suddenly due. The higher the current ratio, the more capable you are of paying your short-term bills. Suggested current ratios typically lie between 1.5-3. Using the Current Ratio indicator allows the CFO to assess the overall debt burden of the company. The ratio expresses a firm’s current debt in terms of current assets. For example, a ratio of 2 indicates that the company has 2 times more current assets than liabilities. This shows that the company is not highly leveraged and thus in a less risky posture.
In Part 2 of this Blog we’ll take a look at two other KPIs: Inventory Turnover Ratio and Accounts Receivable Turnover Ratio.