Are KPIs Right for YOUR Business?

By Larry Ventimiglio

Periodic financial reporting is generally the foundation for reporting performance results for most businesses.  Corporate management teams, hopefully, pay close attention to this information, and utilize the information as “decision support tools” to drive more successful performance.  While the customary format of reporting takes three forms (Balance Sheet, Profit & Loss Statement, and Cash Flow), this information is often broken down into various forms of percentages, ratios, and multiples as is desired.

What Are KPIs and Why Are They Important?

So that having been said, what is a KPI and why should I be interested in reading about them?  Key Performance Indicators are also known as KPIs.  KPIs are more narrowly targeted segments of information to help managers and employees gauge the effectiveness of various functions and processes which are identified as critical to achieving performance success.  As a result, KPIs are closely linked to an organization’s strategic plan and the associated goals which cascade downward throughout the organization.  Several examples include:

A goal within the customer satisfaction area of the strategic plan may be to retain 90% of existing accounts for a minimum of 5 years.  A customer support team might measure the percentage of repeat business from customers who respond with high post-product delivery survey ratings, number of customer complaints, and responses to customer satisfaction surveys.

A sales team might track the number of new customers added, average order size, average order pipeline size, to assess progress in revenue growth over a specified period.  Additionally, sales management may track number of sales calls, number of sales calls to existing customers, new customers, or types of customers (industry categories), sales of new products, or sales of existing products.

A production team might measure these seven common KPIs used in production:

• Count-amount of product created, by shift, over time, or since the last machine changeover.
• Reject Ratio-measures product scrap. The goal is to minimize the amount of scrap created.
• Rate-measures the speed at which goods are produced.
• Target-Target values are set for output, rate, and quality.
• Takt Time-This refers to the amount of time it takes to complete a task. It can refer to the cycle time it takes for a specific operation, or it can refer to the amount of time required to produce a product.
• OEE (Overall Equipment Effectiveness)-This is a measure of whether resources (personnel and machinery) are being used efficiently. A higher OEE value means more efficient use of resources.
• Downtime-Measures time that production is delayed. Downtime means lost profits, so tracking downtime is one of the most important KPIs for a production organization.

A marketing organization might measure the contribution of web-based orders.

Human resources might measure employee turnover, effectiveness of training, or time required to fill open positions, as well as other related metrics.

Each area of a business will measure the efficiency of processes and quality metrics which will help them increase the “value-added” from their area of the business.

Managers and key stakeholders will monitor the indicators over time, and a good vehicle to accomplish this review is a quarterly goal report-out routine.  This provides both managers and employees periodic opportunities to mutually succeed together by reviewing progress achieved and adjusting plan and action programs as needed to insure progress in achieving  performance improvements in support of the organization’s strategic goals.

Although KPIs are Important, Are YOU Making Money? 

So, your business has a strategic plan with strategic objectives,  shorter-term goals cascade downward to all business areas, KPIs have been identified, are being measured, and are being periodically monitored, business activities are being tweaked to insure productivity improvements.  All this sounds great, BUT is your business making money?

While we each have various definitions of business success, there are several key financial metrics that can help you understand your business’ financial success-or not so much.

• Pre-Tax Profit Margin – This metric is probably the most important to understand. It identifies (in terms of percentage) how much profit the business earns from every dollar of sales.  It is expressed as pre-tax income divided by sales.  This percentage needs to be as high as possible.  This is a measure of operating performance.

• Gross Profit Margin – This metric indicates the percentage of sales revenue that is not paid out in direct costs (cost of sales). It is important because it indicates how many cents of gross profit can be generated by each dollar of sales.  The higher the better.

• Current and Quick Ratios – These two metrics are considered fundamental liquidity ratios. They provide a view of how well the business can meet its financial obligations, and they are generally analyzed together.  Liquidity is very important in a business’ ability to meet the unexpected.  Without adequate liquidity, a single unexpected event can severely damage a business.

Current ratio is expressed as current assets divided by current liabilities.  It shows whether assets you can convert to cash quickly (within a year) will cover what you must pay off soon (in less than a year).  A ratio of less than one means the business could run short of cash within the next year unless it can generate additional cash.  The inclusion of inventory in the calculation may distort perception of the business’ very short-term cash flow, however.

Quick ratio is typically expressed as cash plus accounts receivable divided by current liabilities.

I’ll note that neither of these ratios is flawless.  They both have limitations and should be best utilized in conjunction with each other.

• Accounts receivable days and accounts payable days – These are also key financial indicators. A business may not be receiving payments quickly enough, or it may be paying suppliers too quickly.

Accounts receivable days is expressed as accounts receivable balance divided by sales times 365 days.  For this metric, the lower the resulting number the better, but it will vary based on negotiated payment terms..

Similarly, accounts payable days is expressed as accounts payable divided by cost of goods sold times 365 days.  This metric is a rough indicator of how timely a business is in meeting payment obligations.  This metric will also vary based on negotiated payment terms.

• Interest Coverage Ratio – This metric measures a company’s ability to service debt payments from operating cash flow (EBITDA). This ratio is a good indicator of credit quality, so obviously, the higher the better.

• Debt-to-Equity Ratio – This leverage metric indicates the composition of a business’ total capitalization – the balance between money or assets owed versus the money or assets owned. Generally, creditors prefer a lower ratio to decrease financial risk while investors prefer a higher ratio to realize the return benefits of financial leverage.

• Debt Leverage Ratio – This ratio measures a company’s ability to repay debt obligations from annualized operating cash flow (EBITDA). This is also a good indicator of credit quality, so the higher the better.

• Return on Equity – This metric measures how much profit is being returned on the shareholders’ equity each year. It is a vital benchmark from the perspective of equity holders in a business.  The higher the better.

• Return on Assets – This metric measures a company’s ability to use its assets to create profits. It indicates how many cents of profit each dollar of asset is earning per year.  This is an important metric for businesses requiring a heavy asset base to operate.  The higher the better.

The Bottom Line 

A business is comprised of multi-disciplined components (i.e., Sales, Marketing, Manufacturing, Research, and Administration) which are in constant motion and (hopefully) synchronized with each other.  The successful business “leader” Manages, Organizes, Directs, and Controls each of these components and, as a conductor of a symphony, successfully drives them toward the foundational purpose of the business – the accumulation of corporate and personal wealth, or NET INCOME.  KPIs can be important tools to help business leaders, or owners, manage the business more successfully.  Perhaps KPIs can help YOUR business become more successful.  If so, I can help you to get there.

 

What does “success” mean to YOU? 

For more information on how I can help your business team achieve greater success, give me a call, or visit my website @ www.LJVBusinessSolutions.com

 

 

Larry Ventimiglio

LJV Business Solutions, LLC

843-245-9753