Acronym Soup: Finance and Accounting KPIs
B2B…CTR…CRM… No, I am not speaking robot, I am speaking business! There are a ton of acronyms in the business world and while some may be standard to you, it’s still easy to get lost in it all. Key Performance Indicators, or KPIs, are one (of the many) abbreviations that when used in the right way, can generate insights into peak company and employee potential. But, what are KPIs actually providing?
To put it simply, KPIs are numbers that can be analyzed to determine whether or not a company is on track to meeting its goals. While KPIs look different across industries and companies, knowing what they all mean and which ones your company should track is critical for success.To help you out a bit, below is a guide to a few finance and accounting KPIs and, of course, how to choose which ones are right for your company.
Accounts Payable (AP)
Accounts payable (AP) represents the money that your company owes its creditors. Saying a company has a high current accounts payable and a low cash balance means it owes more than it owns, which obviously does not indicate success. KPIs — remember, Key Performance Indicators — related to a company’s AP essentially keep track of the cash going out, or the cash outflows. You could see accounts payable turnover ratio, the number of invoices with errors, days payable outstanding, and cost per invoice, among others, in these KPIs. Still with me on this one? Slow payments, mistakes, and expensive invoices can lead to late fees (more money you owe!), unnecessary costs (more money you owe!), and missed discounts (ability to pay less!), so you want to track these numbers in order to gain greater consistency and control over AP – essentially, gain control and consistency over how efficiently you pay people what you owe them.
Accounts Receivable (AR)
Payable, receivable, see the pattern? Accounts receivable (AR) is, inversely, which hopefully makes it easier to remember, the amount of money owed to a business – what your customers or otherwise owe to you. Just like AP, AR also impacts a company’s cash flow, if you can imagine. A high current AR value could mean that a business has cash coming its way, but (!) it also could indicate a relaxed collection process where some customers never end up paying, which, hello, is not good. Measuring the average collection period, average days delinquent, accounts receivable turnover ratio, and collection effectiveness index allows a business to visualize the effectiveness of their collection policies, and make potential changes to increase cash flow. Meaning, if you keep track of these numbers, you will not become one of those ‘relaxed’ companies that loses money because the debts aren’t being paid and so AR stays too high. You can tell your clients, show us the money! Well, maybe not like that, but you know what I mean.
By the way, you must be good at math, right? Because the next couple of acronyms we will be doing some equations…
Working Capital (WC)
Current Assets – Current Liabilities = Working Capital
To explain a bit more, this KPI tests a company’s liquidity (availability of funds) and ability to meet short-term financial obligations (short-term payments) through assets like cash and AR (this you just learned about!). Having a WC greater than 1 just means a company’s current liabilities (something that could put the company at a disadvantage) are covered by its current assets (like cash!).
Current Ratio (CR)
Current Assets / Current Liabilities = Current Ratio
This ratio shows the proportion of current assets (like cash!) to current liabilities (something that could be bad!), and demonstrates a business’s ability to pay its bills, or its finances, within a year. A high ratio means a company has the ability to pay because of the existence of current assets like cash, inventory, and AR (remember?). You really want a ratio of 1.5 to 3 – still guessing you are good at math. A ratio of less than 1 means that there’s not enough money to keep the bills paid, that is if they were all to be due at the same time, which they might not be but it still feels good to have a safety net. Plus, the CR gives insight to stakeholders, investors, and creditors, generally important people, about the company’s operating efficiency and method of funding growth.
Debt to Equity Ratio (DER)
Total Liabilities / Shareholders’ Equity = Debt to Equity Ratio
This is easy. This KPI indicates how well a company is using its shareholders’ investments to stimulate growth, as opposed to borrowing money to cover costs. A high DER is probably a red flag, because it means the business has expanded through the accumulation of debt rather than through equity. Short and sweet, debt isn’t recommended!
Return on Equity (ROE)
Net Income / Shareholders’ Equity = Return on Equity
ROE measures the amount of income produced from each unit of shareholder equity, which provides insight into an enterprise’s profitability and operational efficiency — and how happy that particular shareholder is going to feel. A high ROE means that equity is being optimized to the fullest to generate wealth and growth. TBH (to be honest), you should aim for this KPI to be around 20 percent for your business. Hope that doesn’t scare anybody!
Gross Profit Margin (GPM)
(Revenue-Cost of Goods Sold) / Revenue = Gross Profit Margin
The GPM determines the amount of profit made per dollar of sales before any expenses are considered. So, before you pay the heating bill in your office or your production building, this is what you’ve made. This margin typically stays the same, unless some drastic change in the company’s production costs or pricing has happened, for which I’m not even going to think of an example because it will be too dramatic. Anyway, a positive margin means that the company has enough funds to cover operating expenses, but unfortunately it does not necessarily mean that it’s making a profit — and that’s where Net Profit Margin comes in.
Net Profit Margin (NPM)
Net Income / Sales = Net Profit Margin
You may see this often, but what does it even mean? This exciting financial KPI measures how much profit a business makes per dollar of revenue. Obviously this is something you may want to pay attention to, especially because determining your business’s profitability will provide a competitive advantage when it comes to pricing, benchmarking, and goal setting in the short and long-term. Important stuff!
Now that you know the KPI’s, which KPIs matter to your organization?
The best way is to really focus on your business objectives and your key metrics because you want KPI to be directly linked to your overarching goals for maximum impact. Best practices are to chose 5-10 target areas to focus on. For example, if your goal is to decrease the amount of time it takes to pay suppliers, focusing on accounts payable turnover or days outstanding would be more appropriate than a KPI like inventory turnover.
Making some more sense?