There are two types of KPIs: leading KPIs and lagging KPIs. Leading KPIs help to predict future performance while lagging KPIs measure past performance.
In most cases, financial KPIs are lagging indicators.
Measuring past performance is an instrumental piece in determining how your decisions have been impacting your business - it’s similar to keeping score during a game. They allow you to narrow your focus and pinpoint the exact areas where you need to improve.
In this article, we’ll cover essential financial KPIs your business should be tracking, and in our next article, we’ll dive into leading indicators.
Table of Contents:
Why Track Financial KPIs?
Financial KPIs (key performance indicators) provide a snapshot of the past financial performance of your business. They help identify areas of improvement and provide you with the information you need to make crucial business decisions.
But in order to do that, you have to track the right financial KPIs. These numbers will tie in with your business goals so that you can measure progress and make the necessary adjustments should you need to course correct.
Before we begin, monitoring your short-term cash flow is one of the most impactful financial measurements for your business. It allows you to make more informed decisions in real-time.
Prioritize Short-Term Cash Flow
Cash is king in the business world, so tracking collections and outflows is essential.
Considering most financial KPIs are lagging indicators, short-term cash flow reporting is a great complement as it is more of a leading indicator from a financial perspective.
At a2 advisers, we recommend keeping tabs on your cash collections and outflows weekly.
To find the information you need for tracking your cash flows, look at these items regularly:
Bank accounts
Outstanding invoices (aka accounts receivable aging)
Outstanding bills (aka accounts payable aging)
We use FinDaily.io. After connecting your bank and accounting, you can build a custom email based on your business’s needs. You’ll be able to see up-to-date numbers automatically from the comfort of your inbox.
With a strong pulse on cash collections and outflows, you’ll have a good picture of your business’s financial position and can dive deeper into your financial KPIs.
Financial KPIs to Track
You can overwhelm yourself by tracking too many metrics, so we (a2 advisers) recommend starting simple.
In this case, less is more. Considering most financial KPIs focus on the past, measuring the right 3-5 indicators will give you a strong base of information.
Here are the financial KPIs we recommend tracking:
Cash Reserve
As the name implies, cash reserve measures the amount of money a company has in its reserves.
A healthy cash reserve provides a buffer against unexpected expenses and gives you the option to pursue opportunities when they arise. Think of this money as a safety net.
We recommend building a 2-3 month reserve. Meaning you should be able to run your business for 2-3 months with the money in your reserves.
Contribution Margin % ((Sales – cost of sales – direct labor)/sales)
The contribution margin measures the percentage of revenue that is left after subtracting all direct costs associated with delivering a service.
This KPI is important because it provides a clear indication of the profitability of a service. It’s a simple but high-level gauge of pricing.
However, we often see cost of sales and/or direct labor included in operating expenses, which causes them to calculate their contribution margin incorrectly. Restructuring your financials will correct this issue. Our Chart of Accounts blog can help you with this.
Typically, the higher the contribution margin the better, but a “good” margin varies by type of business. For example:
Trade services should have a contribution margin above 35%.
Professional services should have a contribution margin above 50%.
Operating Profit % (operating profit/sales)
Operating profit % measures the percentage of revenue left after subtracting all costs associated with operating a business. This KPI is important because it provides a clear indication of how efficiently a business is being run by gauging its profitability.
For most businesses, the operating profit % should be, at minimum, 10%. However, professional services should aim for a % at or above 20%.
Labor Efficiency Ratios (from Greg Crabtree’s Simple Numbers)
Labor is the #1 expense in the services business but rarely do we see metrics on it.
Businesses should be tracking the Direct Labor Efficiency Ratio (dLER) and the Management Labor Efficiency Ratio (mLER).
Direct Labor Efficiency Ratio (dLER)
Tracking dLER will give you a better grasp of the efficiency of your direct labor. This ratio will tell you how much every $1 spent on direct labor equates to X dollars in gross profit.
dLER can be calculated by dividing the gross margin by direct labor costs. While the ideal dLER is unique to each company, $3 or better is a good target amount for this KPI.
Below is an example of how to calculate dLER:
Management Labor Efficiency Ration (mLER)
mLER measures the efficiency of management labor. This ratio will tell you how much every $1 spent on management labor equates to X dollars in contribution margin.
mLER can be calculated by dividing the contribution margin by management labor costs. mLER is similar to dLER in that the ideal number is unique to each company, however, $3.50 or better is a good target for this KPI.
Below is an example of how to calculate mLER:
Let’s Recap
Financial KPIs are an important tool for measuring and tracking the success of a business.
Changes in financial KPIs over time can help business owners and managers identify areas of improvement and make more informed decisions about where to devote resources in the future. They’ll also help ensure that strategies and processes are effective and efficient.
To ensure you’re tracking the right financial KPIs, focus on these:
Cash reserve
Contribution margin %
Operating profit %
Labor Efficiency Ratios
Direct Labor Efficiency Ratio
Management Labor Efficiency Ratio
To learn more about the ins and outs of financial KPIs, check out our cohort by clicking here!