The importance of cash flow cannot be underestimated because it’s literally the lifeblood of a business. Simply put, it is the amount of cash that is generated from the activities of a business that is used to pay expenses, compensate investors, and make further investments.
And just like our own human blood, cash needs to flow smoothly. Among other things, blood carries oxygen and nutrients and contributes to many vital functions in our body. Using that analogy, it is easy to see why watching the vital signs of our business is crucially important to ensure that everything is flowing as it should be.
This article is going to outline some key performance indicators (KPIs) we feel are important in tracking business operations. It’s important to understand these concepts thoroughly and recognize any warning signs. Besides helping uncover any weak points in your business, these KPIs will also increase awareness about what works best from an operations or inventory perspective, allowing you to refine existing strategies for greater profitability and overall success.
Top Financial KPIs to Keep an Eye On
Here are our top 10 KPIs to watch to ensure that your cash flow management is moving in the right direction. Please note that KPI comparisons can be tricky because benchmarks vary widely depending on the industry.
1. Operating Cash Flow/Free Cash Flow
The financial success of a company's core business activities is typically determined by its operating cash flow, a KPI that estimates if a business can generate enough positive cash flow to pay expenses and grow its operations.
Free cash flow is a related yet somewhat different metric that is often comparatively evaluated when looking at operating cash flow. The main difference is that operating cash flow determines if a company has enough cash to pay their bills while free cash flow tells investors that there is enough cash to pay creditors, buy back shares or pay out share dividends.
There are two ways to calculate operating cash flow: the direct and indirect method. The simpler and more direct method is calculated by taking the difference between revenue cash inflows and expense cash outflows. The indirect method takes into account non-cash items like taxes and depreciation when determining cash flow.
2. Working Capital
Working capital gives a clear indication if a business can clear its short-term debts and is calculated by taking the difference between a company’s current assets and current liabilities.
An important point to keep in mind for this calculation is that there is a variety of assets and liabilities on a balance sheet, particularly where capital expenditures are concerned. Determining the proper category for what makes a liability or asset “current” is an important factor in determining this KPI.
3. Current Ratio
The current ratio is the same as working capital. This metric is calculated by taking current assets that are cash or will be converted into cash within a year, and subtracting liabilities that can be paid off in less than a year.
4. Debt-to-Equity Ratio
Business owners and prospective investors are always interested in how much leverage the business is using. The debt-to-equity (D/E) ratio provides this key metric by comparing a company’s total liabilities to its shareholder equity.
A high result typically indicates that a business is a high risk to shareholders however what is considered “high” depends greatly on the industry. Some industries (like the tech industry) typically have higher D/E ratios due to start-up and development costs while other established businesses may have lower ratios.
5. Accounts Payable Turnover
The accounts payable turnover ratio measures liquidity in the short term and represents the ability of a business to pay off its suppliers. It is calculated by subtracting the accounts payable balance at the beginning of the period from the balance at the end, and dividing the result by two.
6. Accounts Receivable Turnover
The accounts receivable turnover ratio is used to determine how much efficiency a company generates in collecting money owed by clients. A high ratio may indicate that the company attracts quality clients while a low ratio may signify that its collection efforts are inefficient.
7. Inventory Turnover
Inventory turnover is a metric that demonstrates how well a business turns over its goods during a specific time period. Many factors go into this calculation, including marketing and pricing strategies, product quality, and consumer preferences.
Low turnover may represent poor sales or inventory management while a high ratio may indicate strong sales or supply chain issues.
8. Return on Equity
Return on equity indicates how effectively a business uses its assets to create profits. Calculated by dividing net profits by average shareholder equity, this ratio is an important metric that can vary widely between industries and should only be compared to industry peers.
9. Quick Ratio/Acid Test
Similar to the current ratio, the quick ratio indicates the short-term liquidity of a business to meet its short-term obligations. The main difference is that the quick ratio or acid test uses assets that can be most quickly converted to cash to pay off current liabilities quickly.
10. Net Profit Margin
Net profit margin is the ratio of net profits to revenues and demonstrates how much net income is created as a percentage of revenue. It provides a reliable measure of profitability by demonstrating how much each dollar collected from revenue is being converted into profits.
A Final Word on Cash Flow KPIs
These top KPIs can help companies determine how healthy their operations are by measuring the efficiency of cash flow throughout the business. There are dozens of different KPIs available to measure every aspect of an operation, and some are more important than others depending on the industry and specific sector.
The right accounting firm can identify the financial KPIs that are best suited for your business in addition to tracking them in order to ensure that your company’s cash flow is moving in a positive direction. Contact us for an appointment today to learn more about what strategy will bring the greatest benefits to your business for greater cash flow in the future.