Using KPIs for Effective Financial Management
USING KPIs FOR EFFECTIVE FINANCIAL MANAGEMENT
The basic management report usually comes in the form of a balance sheet and an income statement. A balance sheet tells you what are your assets and liabilities at a certain point in time whereas an income statement records how much profits (or losses) you are making in a period of time.
It is good practice to include income statement and cash flow forecasts as part of your routine reporting. Business forecasts are forward looking and can help business owners plan ahead, especially if you need to know what the breakeven point is and whether the business requires additional funds to sustain operations.
Each business should look into devising its unique key performance indicators ("KPIs") to measure, monitor, and track its performance over time. For example, if you are in the restaurant business, the KPIs such as food cost percentage to sales, wage cost percentage to sales, sales turnover by seating capacity, sales per square foot, average bill per customer, etc will be relevant. If you are in the service industry, you may want to track the average sales and gross profit over headcount, average salaries over headcount, etc. When a reported KPI is out of the normal range, a red flag is raised to prompt Management to investigate the issue and initiate quick remedial action to fix the problem.
Financial ratios can also be part of the KPIs including in management reporting to track the business's overall financial performance. Profitability ratios (such as gross profit margin, return on investment) measure the quality of your profits. Activity or efficiency ratios (such as stock turnover ratio, average collection period) measure your effectiveness in the use of resources. Liquidity ratios (such as current ratio and quick ratio) measure the ability of the business to pay its current debts. Coverage ratios (such as debt to equity ratio, interest coverage ratio) mechanism by incorporating safety markers on the business reporting system ensures the business stays on track.
A. Profitability Ratios
Profitability ratios are used to measure a business' ability to generate earnings as compared to the expenses and other relevant costs incurred during a specific period of time.
Some entrepreneurs chase after revenue at the expense of margins as they are eager to beat their competitors, perceiving growing revenue as an indication that the business is growing stronger. If they take a close look at their numbers, they may be surprised that 80% of their profit margins are contributed by 20% of their sales. Looking at the revenue of a business alone often doesn't tell the entire story. An increase in revenue is good, but if it requires the business to hire many more people, carry much more working capital and invest in a lot more machineries to support the lower margin business, then entrepreneurs ought to ask themselves if BIG is really good.
Return on Assets ratio ("ROA") is an indicator of how profitable a business is relative to its total assets. It indicates how efficient management is at using its assets to generate earnings. The more assets you need to generate the profits, the lower the returns.
Return on Shareholders' Fund ratio ("ROE") is the amount of net income returned as a percentage of shareholders equity. It measures a business's profitability by revealing how much profit a business generates with the money shareholders have invested. Generally, the risk of investing in a private business is much higher, taking into consideration the personal guarantees that business owners often have to give to obtain fund for the business. The returns on shareholders' fund ought to be commensurate with the higher risks for it to be worth the while.
B. Efficiency & Liquidity Ratios
Efficiency ratios are used to analyse how well a business manages its assets before they are converted to cash. It measures how long a business takes to convert stocks to sales, collect its debts from the time the sale is concluded and pay its creditors from the time suppliers' invoices are received.
In general, a business carries inventory so that it can supply goods promptly. Theoretically, the inventory the business should carry is equivalent to the lead time for re-ordering, assuming you are able to replenish the inventory as frequent as you would like. In this case, if the inventory turnover days are longer than the lead time, it is an indication that the business is carrying more inventory than it requires. On the other hand, lower inventory turnover days as compared to the average lead time may mean under-stocking and the business may suffer from lost sales.
By granting credit terms to debtors, the business is indirectly extending "interest-free loans" to its customers. If your customers do not pay when the debts are due, the business will have longer debtors turnover days, which means it takes longer time to convert a sales into cash. You will need to put in place procedures that can help you to collect your debts on a timely manner.
Conversely, when your creditors extend credit terms to your business, they are also a "financier" of your business and the good thing is you do not need to pay interests. You may be able to enjoy "free funding" if you take a longer time to pay your suppliers but you will have to be mindful not to hurt the good relationships with your suppliers. its current assets into cash, it will be able to meet its short-term obligations.
C. Gearing & Coverage Ratios
Gearing is a measure of the proportion of a business' assets that are funded by interest bearing borrowings versus shareholders' fund. Gearing ratio is therefore a comparison of borrowed funds over owner's equity (or capital). The gearing ratio of more than 1 indicates that the business borrow more funds relative to the owner's capital. A business with high gearing ratio is more vulnerable to downturns as the business is expected to continue servicing its debt regardless of how bad sales are. A higher proportion of equity gives the financier comfort that the business owners are committed to investing their own money in the business.
Interest Coverage ratio measures a business's ability to meet the interest payment. In broad terms, the higher the coverage ratio, the better the ability of the business to fulfill its obligations to its lenders.
The interpretations of the KPIs
