How to Use KPIs to Increase Your Profit

Understanding how Key Performance Indicators (KPIs) in your business affect profit is the key to increasing profits. Not all businesses are the same and, therefore, there will be different drivers that will result in increased profits for each type of business. Service-based businesses will have completely different KPIs from a business that sells products, whether they be manufactured in-house, wholesale or retail. Also, increasing revenue is not the only way to increase profits, controlling expenses can be equally as important.

Revenue is the total amount of money earned. It’s the top line, before cost of goods sold, other expenses, deductions and allowances, etc. It shows the ability of a business to sell goods or services but not necessarily the ability to make a profit.

In a service-based business, revenue per hour is one of the most important metrics to watch when you make money on other people's time. It shows how well you manage the productivity and resulting profitability of your people. The hidden costs of turnover, non-billable time, and inefficient time are summarised in one number. You should be measuring how your revenue per hour compares to your budget, the trend (up or down), how this compares to last month, last year and look for any seasonal trends.

Gross Profits or Gross Margin expressed as a percentage of sales is an important KPI for businesses predominantly selling products. Sales less the direct cost of the goods sold expressed as a percentage ensures that increases or decreases in the volume of revenue do not mask other problems. This KPI also shows what proportion of your earnings that are available to cover overheads, both fixed and variable and the resultant net profit.

Net Profit is, of course, very important as it measures the net income after expenses that is available to stakeholders. Again, expressing this as a percentage of sales is useful in eliminating seasonal and other fluctuations in revenue. Beware, however, that fixed overheads e.g. business premises rent, that are unrelated to revenue, may cause fluctuations in the Net Profit percentage that can be misinterpreted.

KPIs are also relevant to the Balance Sheet. An entity’s current ratio is a great example of a very useful financial KPI. The current ratio is the current assets (for example cash and accounts receivable) divided by current liabilities (such as accounts payable due in thirty days or less). This ratio measures the ability of the business to pay its current debts within a defined time period of normally one year or less. A high current ratio indicates solvency and sustainability. A current ratio of between 1.5:1 and 3:1 is considered healthy. If the current ratio is more than three to one, it could indicate the business is holding excess cash instead of investing it back into the business. This will significantly slow the growth of the organisation.

The Accounts Receivable Turnover (debtor’s ratio) is an important KPI. It measures how well clients pay their invoices within an allotted timeframe (for example, net 30 or net 60 days). The formula for calculating annual accounts receivable turnover is Net Annual Credit Sales divided by Average Accounts Receivable. The KPI requires knowledge of the net credit sales, which are any amounts not paid upfront in cash. It also requires calculation of average accounts receivable which is simply the beginning Accounts Receivable plus the ending Accounts Receivable divided by two. The accounts receivable turnover ratio shows how many times the accounts receivable turned over in the time period being measured. By calculating the accounts receivable turnover for a year and dividing 365 days by the number of times per year the Accounts Receivable turns over, results in the number of days on average it takes to receive payments.

Understanding the working capital ratio will assist in planning future strategic moves such as hiring new team members to scale the business or invest in new equipment. It also alerts business owners to the need for funding to keep the business moving forward. Similar to the current ratio, working capital is calculated by comparing the business’s current assets to current liabilities. Both positive and negative working capital give insight into the state of the business and the success of the business strategy.

These are just a few of the KPI that are important in analysing the success of your business. If you would like more information on how to KPI to increase your profits, please contact the Archer Gowland Redshaw office on (07) 3002 2699 | info@agredshaw.com.au.