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Financial KPIs: How Healthy Companies Select The Right Metrics
Take a look at the step-by-step strategy—and sample metrics—a healthy for-profit organization may use to determine its critical financial KPIs.
At the most basic level, a financial key performance indicator (KPI) is a type of measurement that helps you understand how your organization or department is performing. A good financial KPI should help you and your team understand if you’re taking the right steps toward your strategic goals.
But before you start selecting financial metrics to measure, note that there is a major difference between choosing just any metrics and the correct metrics. Many individuals and organizations are inclined to take shortcuts with their strategy, and thus with regards to their KPIs—but that approach is doomed right from the start.
Below, we’ve outlined the step-by-step strategy a for-profit organization may follow to determine its critical financial metrics—as well as a number of sample financial KPIs to get you started. (Nonprofits and municipalities can use this as a general guide, but note that some steps and pointers may not be in perfect order.)
Financial Key Performance Indicator (KPI) Strategy
Healthy companies know it is imperative to approach the creation of metrics as part of an overall strategy. Below are some of the steps they take and questions they ask to arrive upon the right financial KPIs:
- Where do you want to be in five years, and what does that look like financially? For example, let’s say your goal is to triple the company’s profits in five years, which translates to making $100,000 in profit five years from now
- What will be the key drivers toward achieving that goal? You now have to consider what you need to do in order to triple your profit in the given time frame. To do this, it’s important to determine two or three things that will move your business forward. This might include:
- Launch new products and get sales from those new products.
- Create new partnerships and get revenue from them.
- Raise your prices.
- Drive your sales through better marketing.
- Sell more to existing customers.
- Sell to new customers in new markets.
- Determine what percentage of your financial goal is going to come from each of those two or three key drivers. You may determine:
- New markets: $30,000.
- New products: $50,000.
- New partnerships: $20,000.
- Put financial measures in place to track if you’re making progress along the way. If you want to be sure that you make $50,000 through new products, you’ll need to have the financial measures around new products so you know whether or not they are profitable.
- Have systems in place that can track the measures. Not only do you need to have measures in place that track your goals, you need to be able to track your financial KPIs. In other words, you can’t simply hope to grow your new markets—you need to have a way to measure their growth. For example, you may need to put an accounting system in place that can track these new product profits.
Sample Financial KPIs List
Most organizations divide their financial KPIs between five categories: profits, revenue, expenses, efficiency, and capital. Below, we’ve outlined a few sample financial KPIs you may consider measuring beneath each category. Note that these financial KPIs work for many organizations, but they may not work for your organization based on your strategy.
Profit isn’t always as cut and dry as it seems; there are many different ways to measure it:
- Net profit (revenue minus expenses).
- EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization).
- Cash or accrual profits.
- Reserves for various contingencies (i.e., bad debt or vacations.)
You need to have policies and formulas in place for measuring revenue that everyone—from management to sales to finance—agrees on, because many people are compensated on revenue. Depending on your line of business, there are different revenue metrics to consider:
- Monthly, yearly, or quarterly sales.
- Monthly cash flow.
- Net revenue (revenue minus returns or revenue minus broken products, depending on whether or not you’re going through a distributor or a retailer).
- Revenue and reimbursed revenue. For example, if you’re a healthcare organization and you have an operation you normally charge $10,000 for, not all patients (or their insurance companies) will pay the full $10,000. Some will end up paying $9,000, others $6,000, and some patients without insurance may be given the operation for free in special circumstances. From a revenue standpoint, how do you count all of those unique instances?
Make sure your company has an internally-accepted definition of cost. This is particularly important because of the intricacies of tax codes. Various taxing entities provide policies and incentives to encourage depreciation or repatriation of money, which can change your formula for cost.
- Cost of goods sold (i.e., the direct cost to make the product).
- Overhead as a cost. In other words, what percent of business is not directly related to revenue? This is very important to see whether or not a nonprofit organization is operating efficiently.
- Cash vs. accrual.
- Turnover rate. If a cereal box takes up one unit of space in your grocery store, you need to determine how many cereal boxes you can fill in that space in a given time period. This is not how many you sell, but how many you sell that would sit in that same spot again and again.
- Ability to collect on bills.
- How quickly you pay your bills.
In capital-intensive businesses—like factories or data centers—there are three critical measures you may want to look at:
- Debt. Depending on your business, this financial KPI may be the debt to cashflow ratio or debt to revenue ratio.
- Return on invested capital (ROIC). This measure looks at what kind of return you’re getting for investing in a new manufacturing line, distribution center, call center, etc. You should be able to track a reduction or other costs (like distribution time, mileage, warehouse holding time) to create a return on invested capital measure.
- Cost of capital. This is your borrowing cost—and some are of the opinion that your ROIC should always be higher than your cost of capital.
Two Cautions Before Moving Forward
There are two dangers associated with selecting financial KPIs you’ll want to watch out for:
- The bias of the KPI selection committee may come through. Financial key performance indicators are often chosen by the heads of the finance department. This can become problematic if managers select KPIs based on previous experience or comfort level. For example, if a manager came to a for-profit organization from a municipality, her bias may be toward a number of financial metrics she’s worked with previously—and those metrics may not be appropriate in your organization. So it’s critical that the COO or presidents of different departments in the organization clearly articulate the overall strategy and work closely with finance to create the best financial measures.
- Tying incentive compensation to financial metrics can be motivational or catastrophic. Unfortunately, some individuals in an organization may try to shortcut the strategy and code of conduct in order to achieve their metrics (and thus, receive their bonus). You’ll want to keep an eye on this process and not allow any shortcuts if you choose to use it.
If you want a head start on your financial KPI planning, take a look at the 108 financial metrics we’ve compiled in this free spreadsheet. Just click the button below and download it today!