Note: How to calculate the ratio is briefly described under the formula section.
FINANCIAL KPIs:
Financial KPI (key performance indicator) indicates how well the business performs in terms of calculating profitability, debt and liquidity. It offers a straightforward view of the financial results of the company and confirms, by monitoring KPI, if a company is achieving its long-term goals.
It’s always better to track the progress of an organization as accountants deal with budgets and expenditures, it is also important to keep the company’s leadership in the loop and reminding them of any major financial steps. Here are some of the KPIs listed below:
NET PROFIT MARGIN:
DEFINITION:
Net profit is the figure obtained after deducting all expenses including interest and tax. It is simply calculated by dividing the net profit to gross revenue, to provide a clear view of a business’ real earnings after costs have been paid for.
FORMULA:
The net profit acquired after deducting all operating expenses is divided by gross sales.
Net profit margin= Net profit/ Sales*100
IMPORTANCE:
Net profit margin is an important KPI as it lets the owner see a clear picture of the company’s performance, showing how well the business handles costs and generates profit.
EXAMPLE:
Let’s say that the company makes $50,000 in gross sales and the cost of manufacturing the goods is $10,000, with operating expenses amounting to $5,000. In this case, the company will have a net profit margin of 70 per cent, which means the company is making a reasonable profit.
Find this calculation confusing? Use this net profit margin calculator.
GROSS PROFIT MARGIN:
DEFINITION:
Gross profit is the difference between sales and COGS, and the division by revenue gives a gross profit margin. A high gross profit margin indicates the good performance of the business, whereas a low percentage is considered unsatisfactory.
FORMULA:
The gross profit is calculated by deducting COGS from sales, and then dividing this gross profit by sales gives a gross profit margin.
Gross profit margin: Gross profit/Sales*100
Gross profit: Sales – COGS
Check out this margin calculator, so that you never get your profit margins, wrong.
IMPORTANCE:
The gross profit margin also plays an important role in identifying the performance of the company, as it indicates the performance level of the management using labour and equipment supplies in the manufacturing process. It also shows whether sales can adequately cover the costs of the business.
EXAMPLE:
ABC Ltd. has a gross revenue of $120,000 and a COGS of $50,000. The gross profit margin of ABC Ltd. is 58.33 per cent, which indicates that the company can handle its costs more effectively and that there is room for improvement.
ACCOUNTS RECEIVABLE TURNOVER:
DEFINITION:
This ratio reflects the success of the company in retrieving its debts or receivables. It is also known as the debtor’s turnover ratio. Account receivable turnover in days shows the number of days the company will take to recover its debts or the customer will refund its debts to the company.
FORMULA:
Accounts receivable turnover or ART is calculated by dividing net credit sales (after deducting all returns and allowances) by Average accounts receivable. And if one wants to find out how many days it takes an organisation to recover its receivables then divide 356 by Accounts receivable turnover.
Account receivable turnover: net credit sales/ average account receivable
Net credit sales: Credit sales – sales return and allowance
Average account receivable: (Opening account receivable + Closing account receivable)/ 2
In days:
Account receivable turnover: 365/ receivable turnover ratio
IMPORTANCE:
This ratio demonstrates how efficiently and effectively an organization generates revenue and handles its assets. It is also reflected in days that indicate how many days it takes to recover the debts. It lets the company know how liquid it is and identifies any future threats.
EXAMPLE:
XYZ Ltd. had net credit sales of $200,000 for the year, with total accounts receivable of $50,000. To calculate the receivable turnover ratio, net credit sales of $200,000 will be divided by the average receivable, $50,000, and get four. This means that XYZ collects average receivables four times per year, once per quarter.
Now, if one wants to know how many days it takes XYZ Ltd. to collect the receivables, then simply divide 365 by four which is 91.25 or 91 days.
ACCOUNTS PAYABLE TURNOVER:
DEFINITION:
Accounts payable turnover demonstrates the short-term liquidity factor used to calculate a rate at which a business pays off its suppliers. It indicates how many times a business pays off its accounts payable during the financial year. Its also calculated in days, if there is a need to know how many days it needs the company to pay off its creditors.
FORMULA:
This ratio is simply calculated by dividing all credit purchases by average accounts payable (which is the sum of opening and closing balance of accounts payable, divided by 2). Then simply divide 365 by payable turnover ratio to find out how many days it takes the company to pay off its suppliers.
Accounts payable turnover: net credit purchases/average accounts payable
Average accounts payable: (opening accounts payable + closing accounts payable)/2
In days:
Accounts payable turnover: 365/ accounts payable ratio
IMPORTANCE:
The accounts payable turnover ratio indicates an organisation’s short-term liquidity and creditworthiness. A high ratio means that vendors are given timely payments for loan transactions. A high number may be due to suppliers requiring fast payments, or it may mean that the company is attempting to take advantage of early payment incentives or is working aggressively to boost its credit rating.
A low ratio suggests slow payment for loan transactions to suppliers. This may be due to favourable credit conditions, or it may indicate problems with the cash flow and hence a deteriorating financial situation.
EXAMPLE:
WishList Co. reported annual purchases on the credit of $100,000 and returns of $10,000 during the year ended December 31, 2019. Accounts payable at the beginning and end of the year were $15,000 and $20,000, respectively. To calculate the payable turnover ratio, the company first calculates net credit purchases by subtracting returns of $10,000 from credit purchases of $100,000, which gives $90,000. Thereby dividing this amount by average accounts payable of $17500, gives 5.14 or 5 times of paying off its debts in the accounting period.
Dividing 365 by payable turnover ratio of 5 gives 73 days, which means it took WishList Co. 73 days to pay off its debts in the year 2019.
INVENTORY TURNOVER:
DEFINITION:
It is determined by dividing COGS by an average inventory (the sum of the inventory balance opening and closing, divided by 2). Dividing days in the period by inventory turnover ratio indicates how many days it took the company to sell the inventory on hand.
FORMULA:
It is determined by dividing COGS by an average inventory (the sum of the inventory balance opening and closing, divided by 2).
Inventory turnover ratio: COGS/Average inventory
In days:
Inventory turnover: 365/inventory turnover ratio
IMPORTANCE:
Inventory turnover measures how many times a business has sold and replaced inventory over a given period. This helps companies make informed choices about pricing, production, marketing, and buying new inventories. A low turnover implies poor sales and likely unutilized inventory, while either decent sales or inadequate inventory implies a high ratio.
EXAMPLE:
Company A reported cost of goods sold of $1,000,000. The initial inventory was $320,000 and the final inventory was $400,000. Inventory turnover is calculated by dividing $1,000,000 by an average inventory of $360,000. Company A’s turnover is 2.78 or 3 times, which means that the company sold its inventory 3 times a year. And the division of 365 by 3 gives us 122 days, which tells us that the company takes 122 days to replace the inventory.
RETURN ON CAPITAL EMPLOYED:
DEFINITION:
The return on capital employed or ROCE is a profitability ratio that calculates how effectively a business can generate revenue from its capital employed by comparing the net operating profit with the capital employed.
FORMULA:
ROCE is calculated by dividing net operating profit with capital employed. At times, capital employed is not mentioned so its simply extracted by subtracting current liabilities from total assets.
ROCE: PBIT or operating profit / Capital employed
Capital employed: Total assets – current liabilities
IMPORTANCE:
The return on capital employed (ROCE ) is a financial measure that can be used to determine the profitability and productivity of a business. In other words, the ratio will aid in understanding how well an organization yields revenue from its capital. It helps investors to make well-researched decisions regarding investing in any company. The higher ROCE, the more likely it is to attract investors and generate promising revenue.
EXAMPLE:
Let’s say Walter Ltd. has a net operating profit of $500,000, with $200,000 in assets and $50,000 in liabilities. To calculate Walter’s ROCE, the net income of $500,000 will be divided by its assets minus its liabilities ($200,000 – $50,000 = $150,000). The return of 3.33 times indicates that for every dollar invested in capital employed, the company earns $3.33. The company’s return might be so high because they maintain a low level of assets.