Businesses use various factors to measure their performance; one group of factors is called Key Performance Indicators, or KPIs. Different businesses apply different KPIs; however, there are seven accounting-related KPIs that every business should add to their “must have” plate of KPIs. The seven crucial KPIs are;
- Current ratio,
- Quick / Cash ratio,
- Net Profit Margin,
- AP Turnover,
- AR Turnover,
- Debt ratio, and
- Cost Revenue ratio.
Each of these ratios looks at a business from a different angle to assess the financial health of the business. A brief description of what each KPI measures will help explain why it is an important KPI.
1. CURRENT RATIO
The current ratio measures how liquid a business’s cash is. It looks at how capable a business is in covering its current liabilities. A ratio of 2 or higher is considered good. A ratio of less than 1 should raise concerns regarding the business’s financial health. The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities.
2. QUICK / CASH RATIO
Like the current ratio, the Quick ratio measures how liquid a business is. It also looks at how capable a business is in covering its current liabilities. It is considered a more conservative method than the current ratio, focusing only on cash and cash equivalents. A ratio of 1 or higher is considered good. A ratio of less than 1 should raise concerns regarding the business’s financial health. The formula for the quick ratio is:
Quick Ratio = Current Assets – Inventory – Prepaid Expenses / Current Liabilities
3. DEBT RATIO
The debt ratio measures the portion of a business’ debt that funds the business’ assets. The ideal ratio is less than 1. For example, if a business’s total debt is $100,000 and its total assets are $50,000, then 20% of the business’ assets are funded by debt. The formula for the debt ratio is:
Debt ratio = Total Debt / Total Assets
4. AP TURNOVER
The AP turnover KPI is another liquidity method that measures how often, in a given period, a business can pay its creditors. An ideal ratio is 2:1. A high ratio means more frequent payments are made. For a business to use the turnover formula, it must be in a position where it makes purchases on credit. The formula used to calculate AP turnover is:
AP Turnover = Total Credit Purchases / Average AP Balance for a given time frame.
5. AR TURNOVER
The AR turnover KPI is similar but the opposite of the AP turnover KPI. The turnover measures how quickly, in a given time period, a business can collect payments from its customers and extend credit to customers. A high ratio indicates that a business manages its customers’ credit well. Like the AP turnover, a business can only use this metric if it offers its customers service or products on credit. The formula used to compute AR turnover is:
AR Turnover = Net Credit Sales / Average AR Balance for a given time frame.
6. NET PROFIT MARGIN
The net profit margin looks at how much profit of a business is a percentage of income. A higher percentage implies that less income is used to cover expenses. For example, a profit margin of 70% indicates that 30% of a business’s income is spent on expenses. A higher margin is ideal. The benchmark standard a business can measure itself against differs from one field to another. The formula for computing net profit margin is:
Net Profit Margin = Net Profit (Loss) / Total Income
7. COST REVENUE RATIO (CRR)
The final accounting-related ratio we will examine is the Cost Revenue ratio. The metric measures a business’ spending to ensure that it does not exceed its income. The lower the ratio, the better a business is performing. The formula for computing CRR is:
Cost Revenue ratio = Cost of revenue / Total Revenue.
If you have been trying to find ways of measuring the financial health of your business, consider applying these ratios. If you are not sure what the resulting ratios mean, reach out to your CPA for assistance.