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What is a Key Performance Indicator?
Small and medium business owners are pressed for time—they wear multiple hats while keeping their customers, vendors and employees happy. In all of the management, financial strategy and financial metrics tend to get put on the backburner.
The time necessary to critically analyze a company’s progress is simply not there.
Analyzing vast amounts of information quickly and efficiently is critical to the overall health of any company. Key Performance Indicators (KPIs) are mechanisms that allow an individual the ability to decipher large amounts of data in a small compact form.
Incorporating KPIs into the financial analytics of a business will allow management the ability to react quicker to changes, automate decision processes, and in some cases prevent cash shortages.
KPIs are valuable tools for all industries, from manufacturing industry to software as a service (SAAS) to professional sporting teams.
In this post, I’ll define Key Performance Indicators, show a few examples of how they are used in business today, and provide 5 tips when implementing key performance indicators.
Table of Contents
What is a Key Performance Indicator?
A Key Performance Indicator (KPI) is any metric that allows for quick measurement or comparison against a predetermined base. A KPI allows management the ability to measure actual results against a benchmark, internally set goals, or even against prior results.
KPIs can be used for financial data, non-financial data, or a combination of both. Multiple KPIs in a summary form are commonly referred to as a dashboard.
Why is a Key Performance Indicator Important?
KPIs allow for complex analysis of financial metrics in a quick and easy to use format. Analyzing large amounts or multiple sources of data takes time and experience.
This can be an arduous task, especially if management must do this analysis every day, week, or month. KPIs cut down the time necessary to analyze information.
Before setting up a KPI, management needs to determine what is the most important items for the business to analyze. Some businesses will have 3 metrics they want to analyze, and some may have 8 metrics.
Regardless of the total number KPIs, they should be designed to allow for quick review and keep the company on track towards its goal.
All KPIs must have reliable information to properly function.
If an organization is setting up a KPI for the Days Sales in Accounts Receivable (Accounts Receivable ÷ Total Credit Sales in Period X Number of Days), management will need to make sure that the formula is correctly bringing in all necessary information.
If the formula is accidentally bringing in all sales versus credit sales, then the KPI will be of no use and give management a false reading.
Therefore, it is important to not only take the time to properly set up the KPI, but to also test.
The best way to test a KPI is to put extreme examples into the KPI to see it if the results are as expected. Use worse-case and best-case scenarios.
If the KPI makes expected changes, then you can feel comfortable implementing the KPI.
Examples of Key Performance Indicators
KPIs are truly ratios and comparisons. The most used KPIs revolve around cash.
Businesses are concerned about cash flow. Cash pays vendors, employees, and owners.
Running out of cash, especially at a time of opportunity, is one of the biggest fears of a business owner. Therefore, setting up at least one cash KPI is imperative.
One version of a cash KPI is the Cash Reserve. Businesses should strive to have a cash reserve (operating and savings) of approximately 15% – 30% of prior year gross revenue. The calculation every month will be for the 12 months prior revenue multiplied by 15%-30%. This will be the metric to be compared against.
Then compare this metric to actual cash.
In this example, the cash has dropped below the preferred reserve in June 2019 and July 2019. Management was able to identify this trend and, in August 2019, reverse that trend. This KPI allows management the ability to understand where they are at in terms of cash reserve goals.
Another cash KPI is the cash conversion efficiency.
This calculation allows management the ability to see which products produce the most cash. Sometimes the total revenue number can cloud management’s judgement as to the true cash realization of a product.
Below is an example of a business with two products. One product makes up most of the revenue. However, upon further review, it is noted that the product with the lower sales produces more free flow cash.
Product 1 converts $.08 of free flow cash for every dollar of revenue. Product 2 converts $.54 of free flow cash for every dollar of revenue.
This KPI allows management the ability to understand that they may want to allocate more resources to Product 2 to convert more cash.
The above two KPI examples take information from the prior year’s sales, cash from operations by product, total cash, and sales by product.
Reviewing this raw data and arriving at the same conclusion would take quite a bit of time.
The KPIs noted above allow for quick analysis and, in the case of the cash conversion, allowed management the ability to identify opportunities.
Tips and Reminders for KPI
- Start with the top 3 financial KPIs to be analyze. Common KPI financial metrics are Cash Reserve, Days Sales in AR, and Break-Even Analysis.
- Take as much time necessary to set up the KPI.
- Verify the information used is accurate and appropriate—inaccurate data can cause significant issues in the KPI calculation.
- Test the KPI by using extreme examples, both positive and negative.
- Have other executives review the KPI for any errors or improvement.
Streamline and automate the financial strategy of the company. Simple KPIs have just as much value as more complex KPIs.
All KPIs allow a business to move forward and meet its short and long-term goals.
Steven D Hovland is a Certified Public Accountant and a Certified Forensic Accountant. He has 20+ years of experience in auditing, accounting, and forensic investigations. He is the founder of Hovland Forensic and Financial, a virtual CFO service company as well as forensic litigation services.