Commercial success is measured in various ways. Do consumers like your business? Are you a positive presence in the neighborhood? Is your organization a good place at which to work? Though metrics such as these provide clues you can use to build a better business, you also need to account for dollars and cents.
Tracking financial indicators is the most reliable way to measure financial performance. From the overall financial health of your company, to return on investment (ROI) for specific spending campaigns, understanding the way money moves through your organization yields valuable insight.
One proven strategy adopted by small business professionals, monitoring key performance indicators (KPIs) provides direct financial feedback. The indicators touch on diverse aspects of your business financials, illustrating how well you’re doing reaching commercial goals. The finance figures can be used to
- improve operational efficiencies,
- make informed strategic decisions,
- establish and maintain top organizational priorities.
You’ve invested time and money as an entrepreneur, so you have a sizable stake in the success of your small business. Because you may be tempted to bring your own positive spin to hopeful financial analysis, it’s better to rely on objective markers when measuring performance.
Focusing on key performance indicators takes away the subjective element, furnishing facts and figures that reflect actual conditions. When you’re ready to face the financial truth about your business, use KPIs to paint on honest picture, and then adjust your approach for better financial outcomes.
Gross Profit Margin
Before measuring profit you must first account for production costs and expenses, such as sales and marketing. Gross profit margin, stated as a percentage, refers to the amount of revenue that’s profit, after considering what you’ve spent on your product.
Your gross profit margin is equal to revenue minus the cost of goods sold, divided by revenue. When figuring cost of goods, a familiar line item on your tax return, consider only direct expenses related to your products. Operating overhead, taxes, and other expenses are not included in your cost of goods. As a rule, your gross profit margin should be sufficient to cover your fixed expenses, with leftover profit. Industry averages vary, so you should be comfortable reaching the gross profit margin standard in your field.
Many small business owners are rightfully preoccupied with net profit, known as the “bottom line.” For some entrepreneurs, a healthy bottom line means the difference between taking home a paycheck and going without, hoping for better tomorrows. Realizing a net profit is almost always good news, compared to showing a net loss, which doesn’t look good on a balance sheet.
Net profit accounts for all your direct and indirect spending, representing whatever’s left over after you’ve paid all your business expenses. Calculating the figure is as straightforward as adding up every penny spent and then subtracting the total from your overall revenue.
Net Profit Margin
Like your gross margin, net profit margin is expressed as a percentage. However, unlike gross profit margin calculations, net profit also considers indirect expenses, alongside direct costs used to figure gross profit margin.
Comparing gross and net profit margins can help you plan for greater profits. Knowing indirect expenses play a role calculating net margin, for instance, it may be possible to uncover specific efficiencies, by cutting non-essential costs. Industry figures are not uniform, so researching net profit margins common to your field helps dial-in expectations.
Your expressed current ratio states liquidity. It is a formula equivalent to your current assets divided by your current liabilities. Current assets include cash and other assets that’ll convert to cash within twelve months. Examples of current liabilities are debts you’ll pay off within a year.
Current ratio can help you determine whether or not you have enough cash on hand to pay for an expensive purchase. Creditors also find the ratio helpful when evaluating creditworthiness, using it to determine the likelihood a business borrower will make timely repayment. In much the same way lenders consider current ratio, monitoring the ratio on your own provides an early heads-up when cash flow problems are on the horizon.
Aging Accounts Receivable
If billing is a feature of your financial flow, it’s important to understand how customer payments impact your business finances. An aging report lists customer invoices and memos, providing a receivables reference that can help you identify slow-payers and other sources of cash flow irregularity. Armed with the information, you can impose interest charges on late accounts or change credit terms for clients known to keep you waiting.
Ever wonder about your company’s ability to pay short-term financial liabilities immediately? While your current ratio focuses on your ability to pay expenses within one year, the quick ratio essentially measures cash on hand for immediate spending needs. Also referred to as the acid test ratio, your quick ratio is the KPI to focus on when you’re interested in instant liquidity.
Customer Acquisition Ratio
Bringing new customers on board and retaining your best clients are essential pursuits, ensuring a steady revenue flow for the future. Customer acquisition ratio measures how much revenue you expect to earn from a customer, less the cost of acquisition. Revenue expectations from a given customer relate to his or her spending average and frequency, the total of which is offset by acquisition costs such as advertising and promotions. A ratio below one spells trouble, indicating you spend more acquiring a customer than he or she brings to your bottom line.
Research and Development ROI
Measuring return on investment for research and development helps ascertain whether or not money is well-spent in these areas. Each business is unique, with distinct research and development goals. As such, there’s no magic number that indicates a successful campaign. Returns below 5 percent may indicate you’re barking up the wrong tree and that your research and development budget may require reworking.
There are many ways to interpret business success, ranging from personal job satisfaction, to contributions to the greater good. Though it isn’t all about the money, figures don’t lie. Understanding key performance indicators and using the metrics to establish better practices serve as valuable tools, adding to your gut-level instincts about small business.