How to Use KPIs to Increase Profits & Cash Flow
When it comes to understanding your numbers, one of the questions that inevitably comes up is what are key performance indicators, and how do I use them to increase cash flow? To gain insights into those questions, we will highlight a couple of essential tips for understanding KPI’s.
What is a Key Performance Indicator (KPI)?
A Key Performance Indicator is a number that is important and meaningful in monitoring and measuring the performance of your business.
KPIs & Relationships
KPI’s are relevant because you are COMPARING one number to another number to understand the impact of the relationship. These relationships are essential to understanding the financial business model that makes the business profitable and cashflow.
The three biggest KPI’s that determine profitability on the income statement are:
- Cost of Goods Sold
- Operating Expenses
- Marketing and Sales Expenses
Different businesses in various industries have a different relationship to each of these main items that determine the bottom-line profitability of the business.
Example: In a restaurant, the cost structure could be as follows. Also note, different types of restaurants in that industry can even vary as well. This is why understanding the financial model behind your business model is critical to profitability and financial success.
Food Costs $28 28%
Labor Costs $30 30%
Gross Profit $42 42%
Operating Exp $32 32%
Profit $10 10%
The Financial Business Model: KPIs to Hit Profitability & Cash Flow
This restaurant knows if they control food costs to 28%, labor costs to 30% and these two never exceed 58%, and then operating expenses are controlled to hold the bottom-line profit to 10%; their financial benchmarks will have been met. These numbers and their critical relationships are essential to get the finances of this business model working as the model was intended. If they are off, profitably will be off.
This is why understanding your business model, how it compares to others, and the key numbers that determine profitability and cashflow empower us to know what needs to be managed day to day to hit those numbers. For more on that, please see our article on Executing a Numbers Based Strategy or Finally Understanding Your Numbers.
Three of the Most Important KPIs on the Income Statement
Costs of Goods Sold
Some businesses have a cost of goods sold of 30%, 50%, or 60% of sales, which then determine the amount of Gross Profit left over to cover Operating Expenses and produce a profit. Whether you are in the restaurant industry, IT, manufacturing, or construction, the cost of goods sold will be different, and the relationship will be different. Different businesses within the same industries can also have different cost structures, based on different ways of doing business, different niches, and markets.
Businesses also have a different relationship between Operating Expenses and how much it takes in overhead to support the production of the goods or the services. These are the expenses that if you made the ridiculous assumption, you stay in business but stopped doing business what expenses would you still have. Even when you are closed on a Sunday or are a seasonal business, you may have rent or some support staff on payroll regardless if sales are coming in.
Marketing & Sales Expenses
Here the question is how much does it cost you in Sales and Marketing Expenses to generate each additional dollar of new sales? If you can go through the bank and exchange $10 for $20, you would make that trade every time. Marketing is the same, and we want to know, based on where we put our dollars, how much we are getting back, whether it is in generating new leads and converting them into sales, or are the dollars you spend on campaigns and advertisements. In marketing, all activities can lead to supporting the bigger picture. Once a business grows and starts developing consistent cash flow, it becomes more important to see if the sales it was intended to generate happened according to plan or if a new plan of action is needed from our sales and marketing activities.
Drivers Behind the KPI
We also need to monitor the numbers that drive our KPIs. We need to know specific numbers from day to day to manage the financial performance of the business.
Example: Controlling scheduling is how to control labor, then by making sure you have the foot traffic and average spent each time customer comes in, will empower us to influence our numbers during the month while we still can.
Understanding the big picture allows us to understand the details we need to manage day to day and week to week.
KPIs Beyond the Income Statement
It is also important to look at and compare numbers from one financial statement to another.
Example: How much equipment do you have, and what kind of sales can you produce or service with that equipment? Or if you purchase inventory, how long does it take to turn it into a sale? Or how many days is it taking to collect your receivable?
These are just a few examples comparing numbers between each scorecard. Then there is also the trend, the overall direction of sales, expenses, or cash flow is heading. Are things trending positively upwardly? Or downwardly? Is your gross profit relationship getting better or worse?
Example: A restaurant owner once got his Income Statement back and saw his Gross Profit went up 1% each month. He slightly increased his prices the next month, and his Gross Profit got back in line, successfully implementing a numbers-based strategy.
Beware of the Data Monster
We can easily get lost in detail; our ability to execute directly impacts our business results. Executing requires understanding the Big Picture results and underlining details that drive those results; those are the KPIs and drivers. When first learning about our numbers, there can be a learning curve; we think we have to measure everything. We need to be able to keep them simple but also understand them and how to use them to make better decisions. Remember, finances may seem complicated but they are not infinitely complex.
Over time we learn what our numbers are telling us and turn what if into what is. We learn what numbers matter and get us our results, and which ones are most important to manage and monitor for financial profitability and success. And remember, you cannot control what you do not measure!
To learn more about obtaining and implementing these skills and tools in your business please visit www.ewhsba.com or call 262-796-1040.
Recommended Classes to learn more: Cash Flow Essentials & Cash Flow Fundamentals