Why are financial indicators important?
Financial indicators (also known as financial metrics) are critical tools. Here’s what they allow you to do.
1. Track your performance
They give a standard to measure your performance, see how you’re trending over time and where you can make improvements.
2. Compare with peers
They allow you to compare your company against the competition. You can see where you excel and lag, helping you hone your competitive edge.
3. Make decisions
Indicators let you model out decisions and make the right call instead of just winging it and hoping for the best.
4. Stay financially healthy
They reveal how financially healthy your company is. “A business owner may not understand how to calculate the cash conversion cycle, but I guarantee you they understand the pressures of not having enough money to make payroll,” Blackwood says. “Financial indicators help you avoid such problems.”
5. Get loans and respect loan conditions
When you apply for loans, lenders typically want to see your company’s financial indicators and carefully review them. After okaying a loan, lenders also often require the borrower to stay “in covenant,” which means respecting specific levels in the indicators.
For example, a bank could ask you to maintain a 4-to-1 debt-to-equity ratio. If the ratio goes above that, the bank could require you to repay the loan or give additional security.
“We look at financial indicators of businesses very closely,” Blackwood says. “They show whether the company has the ability to generate sufficient cash to maintain operations, which is effectively what pays back long-term debt.”
What are the four main types of financial indicators?
Financial indicators generally fall into four areas that cover key aspects of a company’s financial health.
- Growth—how quickly sales are increasing (or not)
- Profitability—how much money the business is making
- Liquidity—how much cash the company generates and has on hand
- Leverage—its level of short- and long-term debt
Some financial indicators are financial ratios—comparisons between two numbers to show the relationship between them. For example, a company’s debt-to-asset ratio is its liabilities divided by its assets. This tells you if your debt level is reasonable for the size of your company.
Other financial indicators aren’t ratios, such as net profit and sales.
Financial indicators are part of the broader category of all of the key performance indicators (KPIs) that measure various aspects of a company’s performance. Non-financial KPIs cover functions such as sales, marketing, operations and human resources.
What financial indicators should I monitor?
Numerous financial indicators are available to track your financial performance. Below are key ones it’s especially important to track for most companies, small or large. Bigger or more complex businesses may need to monitor additional indicators.
Some indicators fall into more than one category. See the following section for formulas to calculate all of these indicators.
Growth
Monitor your company’s growth to see if you’re on track with your targets and business strategy. Here are the two main indicators for doing this.
1. Sales
This figure (also called revenue) is at the top of your income statement. (This is why it’s sometimes called “the top line.”) You can track both year-over-year sales growth on your annual statements and monthly or quarterly growth on interim statements.
2. Net profit
Net profit is also known as net income or the “bottom line” because it’s typically the last line in your income statement. It’s what’s left over from your sales after the deduction of fixed and variable costs, interest, amortization, depreciation, non-operating items and taxes.
It’s important to track both sales and net profit, Blackwood says. “It’s possible for your sales to go up while profits are actually going down. You could be losing money because your input costs have gone up higher than your sales,” he says.
Profitability
Track your profitability to make sure you’re actually making money, not blowing through all your sales on expenses. Here are the main metrics to monitor that.
1. Net profit (see above)
2. Net profit margin
Your net profit as a portion of sales. This metric may be listed on the income statement below net profit, but not all income statements include it.
Net profit margin is useful for comparing net profit from one time period to the next, or against other firms. Comparing the raw dollar figure alone can be misleading.
For example, if your net profit increases from $500,000 to $600,000, it may look like cause for celebration. But if sales in the same period increased from $5 million to $10 million, your net profit actually fell from 10% to 6% as a portion of sales. Here’s how to calculate net profit margin:
NET INCOME
NET SALES
X 100 (EXPRESSED AS A PERCENTAGE)
3. Gross profit
The amount of sales left after direct (variable) costs are subtracted. “A lot of people just go to the bottom line and say, ‘What’s my net profit?’” Blackwood says. “But you could be missing a whole host of things that influence that, such as changes in various costs. Looking at gross profit helps you understand what’s happening better.”
Usually indicated on your income statement below sales and cost of goods sold (for manufacturers) or cost of sales (retail or wholesale businesses).
4. Gross profit margin
Your gross profit as a portion of your sales. It’s important to calculate this to better compare your performance over time and against the competition. The raw gross profit number isn’t as useful for such comparisons. This is also sometimes called the gross margin.
This number is sometimes given on the income statement below gross profit. How to calculate it:
(SALES – DIRECT EXPENSES)
SALES
X 100 (EXPRESSED AS A PERCENTAGE)
5. EBITDA
A measure of your company’s ability to generate income. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It usually doesn’t appear on income statements, but it’s commonly used to calculate a company’s “core” profitability. EBITDA is also often the basis for calculating a business’s valuation.
“EBITDA is a standard that’s widely used because it’s the normalized level of income that the company created in a certain time period,” Blackwood says.
How to calculate it:
Net profit + interest + taxes + depreciation/amortization
Liquidity
While profitability is important, it doesn’t tell you how much cash you have available in your business from day to day. You may be highly profitable at year-end, but still have serious cash flow problems in the interim.
“If you made a sale but haven’t yet received the money from it, you show the profit from that sale, but your cash flow won’t reflect it yet,” Blackwood says. “Companies should have a good understanding of how long it’s taking them to get their money. Liquidity indicators tell you when your money leaves and how long it takes to come back into your business.”
Here are six of the most commonly used liquidity indicators.
1. Current ratio
The current ratio is sometimes called the working capital ratio. This is your company’s current assets (cash and short-term assets that could be converted into cash within 12 months) divided by current liabilities (short-term liabilities due within 12 months). The higher the number, the better. Here’s the formula:
CURRENT ASSETS
CURRENT LIABILITIES
2. Quick ratio
Available assets (cash, securities that can be immediately converted into cash and healthy accounts receivable) divided by current liabilities. This is more conservative than the current ratio because the quick ratio includes fewer assets. The higher, the better. How to calculate it:
AVAILABLE ASSETS
CURRENT LIABILITIES
3. Average days receivable
The average number of days it takes your company to get paid by customers. A lower number is better. Also known as the average collection period. This calculation has two steps.
Step #1: Calculate your average accounts receivable.
(ACCOUNTS RECEIVABLE VALUE, START OF THE PERIOD + ACCOUNTS RECEIVABLE VALUE, END OF THE PERIOD)
2
Step #2: Calculate days receivable.
(AVERAGE ACCOUNTS RECEIVABLE
NET CREDIT SALES*)
X NUMBER OF DAYS IN THE PERIOD (USUALLY 365)
* Net credit sales are revenues your business generates on credit, less any returns.
4. Average days payable
Days payable is the average number of days you take to pay suppliers. Within limits, a higher number is generally better—though taking too long to pay a supplier can hurt your relationship with them. How to calculate it:
(DAYS IN THE PERIOD X AVERAGE ACCOUNTS PAYABLE)
PURCHASES ON CREDIT
5. Inventory turnover ratio
How many times a year your business converts its inventory into sales. Sometimes referred to as “inventory turns.” The higher the number, the better. How to calculate it:
COST OF GOODS SOLD (OR COST OF SALES)
AVERAGE INVENTORY
6. Cash conversion cycle
How many days it takes your business to convert its investment in production and sales into cash. The cash conversion cycle combines days receivable and payable and inventory turns. A lower number is good. How to calculate it:
AVERAGE DAYS INVENTORY + AVERAGE DAYS RECEIVABLE – AVERAGE DAYS PAYABLE
Although not a financial indicator, Blackwood also strongly advises businesses to use a cash flow forecast. This projection allows you to determine ebbs and flows in your cash flow through the year so that you can anticipate and plan for any shortfalls. You can also use it to model out major investments and business decisions.
“There's almost no better statement for someone to prepare than a cash flow forecast,” Blackwood says. “It doesn’t matter how profitable you are in December if you can’t make payroll in March. A cash flow forecast will show you ahead of time that you may run into problems.”
Leverage
Your level of indebtedness is an essential aspect of your company’s financial health. Being overleveraged can put pressure on cash flow due to high interest payments. It can also put your business at risk if interest rates rise and make it harder to get additional needed financing.
“Leverage indicators show how much financial flexibility a business has to weather different economic climates,” Blackwood says. “If you’re carrying too much debt, banks may not be supportive.”
On the other hand, he says, being underleveraged may mean you’re missing opportunities to invest in your company’s growth. “Most businesses, when they sell more of their product, make more money than the cost of debt,” Blackwood says. “The concept of leverage is that you’re making a profit off someone else’s money”.
“Leverage is an important part of success for businesses. It’s important to manage your debt and be lean and mean—especially when economic uncertainty is high—but you’re less likely to be able to grow (as quickly) if you don’t have some leverage.”
Here are common leverage indicators.
1. Debt-to-equity ratio
How much long- and short-term debt your business has compared to the amount invested by the owners and accumulated earnings. A lower debt-to-equity ratio is generally better. How to calculate it:
TOTAL LIABILITIES
SHAREHOLDERS’ EQUITY
2. Debt-to-asset ratio
Total short- and long-term liabilities divided by total short- and long-term assets. Again, the lower the debt-to-asset ratio the better. How to calculate it:
TOTAL LIABILITIES
TOTAL ASSETS
3. Debt-to-sales ratio
This is your total liabilities divided by sales, with a lower number being best. How to calculate it:
TOTAL LIABILITIES
SALES
4. Debt service coverage ratio
How much EBITDA a business earns for every dollar of interest and principal paid. A higher number is better. The debt service coverage ratio is sometimes calculated with EBIT (earnings before interest and taxes) instead of EBITDA. If capital lease expenses are included in the calculation, the resulting metric is called the fixed-charge coverage ratio.
How to calculate it:
EBITDA
(INTEREST + PRINCIPAL PAYMENTS DURING THE PERIOD)
How do I calculate financial indicators?
It’s very common for businesses to make calculation mistakes and faulty assumptions in their financial indicators, such as misallocating costs and assets. These can materially affect the conclusions you draw.
Ask a financial expert to validate the methodology you use to calculate your indicators. This is especially important for interim statements and other figures not validated by an accountant.
“Mistakes can happen with financial indicators and can lead to poor business decisions,” Blackwood says.
Also be sure that the figures you use to calculate your indicators accurately represent your business. “Verify whether the numbers reflect reality,” Blackwood says. “In your inventory, is it real inventory that you can sell, or is it unsellable inventory that you haven’t written off yet. Do receivables include a bad debt? Are you being realistic about when you’re going to receive the money?”
How often should I monitor financial indicators?
It’s important to review financial indicators regularly through the year, not just in your year-end financial statements. The figures could be dated by the time those statements are available. As well, many of the indicators above aren’t included in the statements and have to be calculated separately.
“In an economy that’s shifting so quickly, year-end statements may not be relevant by the time they are finalized,” Blackwood says. “If you’re making decisions based on your year-end result and interest rates have gone up three or four times since then, you need to take this into account.”
Blackwood recommends tracking indicators through interim monthly or quarterly financial statements and other summaries. Again, validate the methodology with a financial expert to avoid mistakes.
What can financial indicators tell me about my business?
Financial indicators tell you how effectively you’re running your business and inform sound business decisions. They also let you watch your cash flow and gauge how much financing you may need or could take on.
Using financial indicators to their fullest takes some practice and thought about their place in your decision-making. Here are three keys for doing so successfully.
1. Compare and contrast
You can analyze financial indicators in two ways: horizontally and vertically.
- Horizontal analysis means comparing the current period’s numbers to earlier periods.
- Vertical analysis is drilling down into numbers. For example, you could review costs by going through individual items in an income statement.
Both approaches are important. “Get behind the numbers and ask questions,” Blackwood says. “The comparison is the important part. Step back and ask, ‘What does this mean for my business?’ Are sales higher because it was an anomalous year or a longer-term trend? What changed in my variable costs?”
As an example, he cites a business that had $50 million in annual sales, but only $300,000 in net income. A closer look revealed the reason for the low profits: The company was taking on too many projects with low margin.
You may even have to look beyond your financial statements and check numbers for individual products or departments to understand the reasons for certain results. “Just taking the ratio and comparing it is only the first step,” Blackwood says.
2. Determine an appropriate standard
Determine a target level (known as a standard) for each indicator that’s appropriate for your business and industry. Standards can vary widely by industry.
“An accounting textbook may say the standard for a ratio is 1-to-1, but that may not be true for your industry or how you operate your business,” Blackwood says.
“You don’t want to compare yourself to a highly volatile business if you’re a more conventional kind of company that sees nominal growth every year. You may say, ‘Why am I not growing as fast as I should be?’ But you might be making an unfair comparison.”
For example, Blackwood says, liquidity needs can vary greatly between the hotel industry and manufacturers.
“If you're in the hotel business, you're getting cash all the time and liquidity might not be as important to you. But if you’re a manufacturer, you have to invest in people and raw materials, you have to convert that into a finished product, you have to cover overhead, transport your product and get paid possibly 60 or 90 days later. Do you have the cash available to cover these upfront costs?”
3. Integrate indicators in decision-making
Use financial indicators to help you weigh and game out important decisions. Plug in anticipated costs and sales of a decision to see how it could impact the financial indicators.
“Indicators help you validate if your decisions make sense or if you’re putting your business at risk,” Blackwood says.
Next Step
Discover how to use financial indicators for your business to track and analyze data and take the guesswork out of financial planning. Download BDC’s free guide, Monitor your business performance.
