By Olutomi Rone
Business owners must track and monitor financial indicators to analyse their businesses’ performance. However, financial indicators necessary for monitoring performance are by no means generic, not to businesses of a similar size, not to businesses within the same country, not to companies within the same sector or industries, and alarmingly not even to departments within the same business.
The finance function within businesses must be ready to craft the right strategy for the customised design and implementation of the right metrics. But too often, it has been perceived to be a non-revenue generating, number crunching and tunnel vision function. Yet, the finance function is one of the most strategic functions of an organisation.
According to a survey of more than 500 finance professionals in the UK by webexpenses, 60% of the finance professionals felt undervalued within their organisation. About 53% felt they did not get the same respect as colleagues working in other departments.
The secret to extracting the finance function’s strategic value is offering them a seat at the table; else, the finance function is incapable of creating and maximising stakeholders’ return.
With my years of experience in metric design and implementation across businesses with different compositions and in various sectors, I will recommend using the following indicators in addition to more customised metrics.
However, the finance function should consider details like the business model, size, equity composition, PPE investments, manufacturing, and capital structure during the design phase. These top financial indicators should be designed to cover Profitability, Liquidity, Solvency, Gearing, Valuation, and Investments of the business.
Here are the 7 top financial indicators you should monitor on your periodic dashboard as a business owner.
Net Profit Margin
The majority of organisations commonly overlook this primary financial indicator; yet, one of Harvard Business School’s articles on 13 financial measures to monitor highlighted net profit margin as a critical financial metric for any organisation.
This profitability indicator measures the actual percentage of net profit an organisation earns directly related to its total revenue and is calculated by dividing net profit by the revenue in any one period. The higher the percentage of this net profit margin, the better the organisation is deemed to have performed.
High net profit margins mean the organisation has a good pricing strategy and/or operating solid cost optimisation initiatives. However, a heavily geared and capital intensive (PPE heavy) organisation could distort the net profit margin by presenting a lower net profit margin.
Gross Profit Margin
This financial indicator focuses on the direct cost or cost of goods sold and how much of this cost line is used to generate revenue for the organisation. This metric is a fundamental indicator for manufacturing companies as they tend to have higher direct costs than firms whose solutions are more service-oriented.
This profitability indicator is calculated by dividing the gross profit by the organisation’s revenue. Like the net profit margin, it should be compared with ratios from previous periods for the same firm and with other firms within the same sector. A high gross profit margin means the company is efficient in using its resources to produce goods/services.
Cash Flow to Revenue
This ratio is essential for keeping close tabs on cash generation compared to revenue generation; it provides a clear insight into how well the business collects its cash. While companies in the hospitality or aviation space might not have their cash tied down, those in the consulting or telecom infrastructure sector may have another story to tell.
The ratio is calculated by dividing the organisations operating cash flow by its net revenue. For a healthy organisation, we expect a ratio of at least one, a ratio below this could mean an ineffective cash collection system within the organisation.
Quick Ratio
This liquidity ratio measures an organisation’s ability to pay off its liabilities in the shortest possible time frame. It is calculated by deducting inventory and prepaid expenses from current assets and dividing the resulting figure by current liabilities; the ideal quick ratio is one or above.
It evaluates the current assets of an organisation. It allows the user to conduct a scenario analysis that considers what would happen to the organisation should it need to pay off its short term liabilities “quickly”.
In a US study of why businesses fail, 82% of failed businesses experienced cash flow issues; I believe a sizeable proportion of these companies could not promptly convert some assets to cash.
Debt to Equity
This ratio indicates solvency and financial leverage; it examines the organisation’s capital structure and seeks to highlight any over-reliance on debt or equity. The ratio is calculated by dividing total long-term debt by shareholders equity. It shows debt as a ratio of total equity; a ratio of one or higher is considered less risky.
When using this ratio to make comparisons, do so with organisations within the same sector because specific sectors have a higher appetite for debt than others. A caveat is that debt is not always bad for business; it can be used to fund feasible and well-thought-through growth strategies without affecting the structure of shareholders equity.
Price/Earnings (P/E) Ratio
This valuation indicator is a robust measure of the alignment between an organisation’s share price and earnings per share. The ratio is calculated by dividing price per share by earnings per share ((net income – preference dividends)/weighted average of ordinary shares outstanding).
The P/E ratio should always be compared to sector averages. P/E ratios higher than sector average are often perceived as overvalued and risky, while shares with lower than average P/E ratios are often perceived as future moneymakers and allows the investor to benefit from share price increases.
Moreover, consider consulting an industry expert or a professional valuation firm if you need a business valuation. Doing so will give you access to expert knowledge and the necessary tools to accurately assess the value of your business and ensure that you make informed decisions regarding its growth and profitability.
Return On Capital Employed (ROCE)
This is a profitability/investment ratio, and it is often used as a decision-making metric for investment purposes like the P/E ratio. It is calculated by dividing earnings before interest and tax by capital employed (this represents the total amount invested in the organisation).
The metric tells investors how efficiently capital is being used to generate profit. It should be compared to historical figures of the same organisation to establish a pattern for capital utilisation.
All the metrics mentioned above must be interpreted together, meaning that a single promising metric should not be used as a sole positive indicator for your business.
It is important for business owners to have the right set of financial indicators that cover all the critical business sustainability areas. It sets the right accountability tone for the individuals tasked with revenue generation responsibility, small business expense report, and provides a clear target-setting basis for monitoring and performance evaluation.
With these metrics incorporated into periodic management review meetings, business owners can worry less, knowing there is a robust system in place that would identify any potential sustainability or going-concern issues before they are likely to occur.
Olutomi Rone is a director at African Ally, a global staffing solutions company. She started her career in the UK within the banking, consulting and manufacturing sectors. In Nigeria, she has worked in the consulting sector at PwC and was the Head of Business Planning at IHS, she then moved on to be the Chief Operating Officer at Kimberly Ryan Limited.
She holds a BA(ECON) Honors from the University of Manchester, UK and is ACCA qualified. She is a cross-functional leader with 19 years of experience in Business Planning and Analysis, Strategy Formulation, IPO Readiness, HR, Finance and Accounting. Her experience cuts across Finance, HR Consulting, Telecommunications, Manufacturing and Construction Industries.
