The Basics of Key Performance Indicators (KPI) for Finance Managers

KPI Defined

Every finance manager should know what KPIs are, as well as the importance of staying on top of them.? This article covers the basics of KPIs for finance managers.

First, let’s look at four different, but similar definitions. KPIs, according to Klipfolio, “… [KPIs are] metrics used to evaluate the success of an organization or employee in meeting performance objectives. KPIs are categorized into various types, including sales, marketing, financial, operational, and customer-centric KPIs, each focusing on different aspects of organizational performance. Good KPIs are actionable, aligned with business goals, realistic, and measurable” (Klipfolio).? In the article, “What Is a KPI? Definition, Types, Examples and Best Practices,” Filip Stojanovic adds, “[KPIs]…are used to monitor the financial health of an organization and ensure fiscal responsibility, with examples like ‘reduce operating expenses by 10% in the next quarter.’ This definition underscores the specificity and measurability of good KPIs, which are designed to define clear goals and the steps necessary to achieve them” (Stojanovic).? KPI.org defines them as well, but goes on to stress, “[they] ?are crucial, quantifiable indicators of progress toward an intended result. They serve as a focal point for strategic and operational improvement, offering a foundation for decision-making and emphasizing what matters most. KPIs balance between leading indicators, which predict future successes, and lagging measures, which reflect past achievements” (kpi.org ). ?Lastly, Jonathan Silva’s article, “Key Performance Indicators: What Are They & How You Can Use Them for Your Business,” defines KPIs as, “…your guide to understanding every moving part of your business and might just be the most important part of management” (Silva).? To sum up the definition, KPIs are management tools and they are important for evaluating performance, for making informed decisions, and guiding strategic planning.

Basic KPIs for Finance Managers

Finance managers play a crucial role in steering organizations toward financial health and sustainability and they should rely heavily on KPIs to measure the company's financial performance, ensure strategic objectives are met, and guide financial planning. Based on insights from various sources, here are the top five KPIs that every finance manager should be familiar with:

1.????? Gross Profit Margin (GPM): This KPI is essential for understanding how much profit a company makes after covering its direct costs related to producing the goods or services it sells. A higher gross profit margin indicates more efficiency in managing production costs relative to sales (Marr). The higher the GPM ratio demonstrates operational efficiency and good pricing strategies or both. ?The GPM formula is Revenue (R) less Cost of Goods Sold (CGS) divided by revenue (R):

R-CGS/R = GPM

Example:? If a company’s R is $200,000 and the CGS is $120,000, the GPM is $200,000 less $120,000 = $80,000 divided by $200,000 = 40%.? A 40% GPM is a good indicator of a healthy margin. On the other hand, if R is $150,000 and CGS is $160,000, the GPM would be $150,000 less $160,000 = -$10,000 divided by $150,000 = -6.67%. This would indicate there was either an operational inefficiency or a pricing issue or both.

2.????? Net Profit Margin (NPM): Measures the amount of net profit a company generates as a percentage of its revenue. This KPI is crucial for assessing the company's profitability after all expenses have been deducted from total revenue, including taxes and interest (Marr).? The higher the NPM ratio, the stronger the profitability. The NPM formula is Net Profit (NP) divided by revenue (R):

NP/R = NPM

Example: If a company’s R is $500,000 and a NP of $100,000, the NPM is $100,000 divided by $500,000 = 20% which indicates strong profitability. However, if the R is $300,000 and the net loss was $30,000, the NPM is -$30,000 divided by $500,000 = -10%, which indicates a loss after expenses.

3.????? Operating Cash Flow (OCF): This indicates the amount of cash generated by a company's regular operational activities. OCF is a critical measure of the health and sustainability of a company, as it shows whether the company can maintain and grow its operations without needing to secure additional funding (Malnik). The higher OCF amount demonstrates effective cash management. ?This KPI is derived from operating activity cashflow as shown on the cashflow statement. The KPI formula involves adjustments to net income (NI) for changes to working capital and non-cash items such as depreciation, stock-based compensation, amortization, accounts receivables (AR), etc. and are recorded on the income statement that do not involve actual cash outflow during a specified period.

Example: If a company reports NI of $100,000, add back $20,000 in depreciation and makes a $10,000 adjustment in AR, leading to an OCF of $110,000, this will indicate effective cash management. Consequently, if a company has a net income of $50,000, adds back $15,000 in depreciation, but adjusts for a $70,000 increase in inventory, it will result in an OCF of -$5,000, indicating potential liquidity issues.

4.????? Debt-to-Equity Ratio (D/E): This ratio is used to evaluate a company's financial leverage and is calculated by dividing its total liabilities by its shareholders' equity. A lower D/E ratio suggests that a company is using less debt to finance its operations, which is generally viewed as a sign of financial stability (Marr). The lower the D/E the better. This KPI formula is Total Liabilities (TL) divided by Shareholder’s Equity (SE):

TL/SE = D/E

Example:? If a company with $100,000 in TL and $200,000 in SE, then the D/E would be $100,000 divided by $200,000 = .5 which indicates that the company is a low risk as it uses less debt in its financing. Contrasting, if a company has $250,000 in TL and $100,000 in SE, the D/E is $250,000 divided by $100,000 = 2.5 which indicates the company has relied heavily on debt to operate and is a financial risk.

5.????? Return on Equity (ROE): ROE measures a company's profitability by revealing how much profit a company generates with the money shareholders have invested. It is an important metric for finance managers to understand how effectively their company is using equity to generate profits (Marr). The higher the ROE ratio shows efficiencies in equity and profitability. This KPI formula is Net Income (NI) divided by Shareholders’ Equity (SE):

NI/SE

Example: If a company’s NI ?is $150,000 and SE is $500,000, the ROE would be $150,000 divided by $500,000 = 30%. This indicates strong profitability and efficient use of equity.? On the other hand, if NI is a loss of ?$20,000 and SE is $400,000, ROE = -5% which indicates a negative ROE and SE.

The table below summarizes the basic KPI, what it indicates, the formula, and what a finance manager needs to be concerned about – is the indicator positive or in the black, or is it a warning sign or in the red.

Conclusion

These KPIs provide finance managers with a solid foundation for evaluating their company's financial performance, making informed decisions, and guiding strategic planning. However, it's also essential to consider additional metrics that may be specific to the company's industry or business model for a more comprehensive financial analysis.? Knowing the top five KPIs will assist you with staying on top of the financial management of your company.

References

Malnik, Jessica. (2023). “39 Most Important KPIs to Track Across Your Company.” databox.com . databox.com/important-kpis .

Marr, Bernard. (2021). “The 75 KIPs Every Manager Should Know About. bernardmarr.com . www.bernardmarr.com/the-75-kpis-every-manager-should-know-about .

Silva, Jonathan. (2023). “Key Performance Indicators: What Are They & How You Can Use Them for Your Business.” amserv.com . www.amserv.com/blog/business-management/kpis-explainer-how-to .

Stojanovic, Filip. (2023). “What Is a KPI? Definition, Types, Examples and Best Practices.” databox.com . www.databox.com/what-is-a-kpi .

“What Is a Key Performance Indicator (KPI)?” KPI.org . www.kpi.org/KPI-Basics .

“What Is a KPI?” klipfolio.com . www.klipfolio.com/resources/articles/what-is-a-key-performance-indicator .