While you may not have a background in finance, a basic understanding of the key concepts of financial accounting can help you improve your decision-making process, as well as your chances for career success. With a better understanding of how your organization measures financial performance, you can take steps to provide additional value in your daily activities.
Finance can be intimidating for the uninitiated. To help you become more comfortable understanding and speaking about financial topics, here’s a list of the top financial metrics managers need to understand.
Financial KPIs (key performance indicators) are metrics organizations use to track, measure, and analyze the financial health of the company. These financial KPIs fall under a variety of categories, including profitability, liquidity, solvency, efficiency, and valuation.
By understanding these metrics, you can be better positioned to know how the business is performing from a financial perspective. You can then use this knowledge to adjust the goals of your department or team and contribute to critical strategic objectives.
For managers, these metrics and KPIs should be made available internally and distributed on a weekly or monthly basis in the form of email updates, dashboards, or reports. If they’re not readily distributed, you can still become familiar with the metrics via financial statement analysis.
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Financial statement analysis is the process of reviewing key financial documents to gain a better understanding of how the company is performing. While there are many different types of financial statements that can be analyzed as part of this process, some of the most important, especially to managers, include the:
The metrics below are typically found in the financial statements listed above and among the most important for managers and other key stakeholders within an organization to understand.
Gross profit margin is a profitability ratio that measures what percentage of revenue is left after subtracting the cost of goods sold. The cost of goods sold refers to the direct cost of production and does not include operating expenses, interest, or taxes. In other words, gross profit margin is a measure of profitability, specifically for a product or item line, without accounting for overheads.
Gross Profit Margin = (Revenue - Cost of Sales) / Revenue * 100
Net profit margin is a profitability ratio that measures what percentage of revenue and other income is left after subtracting all costs for the business, including costs of goods sold, operating expenses, interest, and taxes. Net profit margin differs from gross profit margin as a measure of profitability for the business in general, taking into account not only the cost of goods sold, but all other related expenses.
Net Profit Margin = Net Profit / Revenue * 100
Working capital is a measure of the business’s available operating liquidity, which can be used to fund day-to-day operations.
Working Capital = Current Assets - Current Liabilities
Current ratio is a liquidity ratio that helps you understand whether the business can pay its short-term obligations—that is, obligations due within one year— with its current assets and liabilities.
Current Ratio = Current Assets / Current Liabilities
The quick ratio, also known as an acid test ratio, is another type of liquidity ratio that measures a business’s ability to handle short-term obligations. The quick ratio uses only highly liquid current assets, such as cash, marketable securities, and accounts receivables, in its numerator. The assumption is that certain current assets, like inventory, are not necessarily easy to turn into cash.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Financial leverage, also known as the equity multiplier, refers to the use of debt to buy assets. If all the assets are financed by equity, the multiplier is one. As debt increases, the multiplier increases from one, demonstrating the leverage impact of the debt and, ultimately, increasing the risk of the business.
Leverage = Total Assets / Total Equity
The debt-to-equity ratio is a solvency ratio that measures how much a company finances itself using equity versus debt. This ratio provides insight into the solvency of the business by reflecting the ability of shareholder equity to cover all debt in the event of a business downturn.
Debt to Equity Ratio = Total Debt / Total Equity
Inventory turnover is an efficiency ratio that measures how many times per accounting period the company sold its entire inventory. It gives insight into whether a company has excessive inventory relative to its sales levels.
Inventory Turnover = Cost of Sales / (Beginning Inventory + Ending Inventory / 2)
Total asset turnover is an efficiency ratio that measures how efficiently a company uses its assets to generate revenue. The higher the turnover ratio, the better the performance of the company.
Total Asset Turnover = Revenue / (Beginning Total Assets + Ending Total Assets / 2)
Return on equity, more commonly displayed as ROE, is a profitability ratio measured by dividing net profit over shareholders’ equity. It indicates how well the business can utilize equity investments to earn profit for investors.
ROE = Net Profit / (Beginning Equity + Ending Equity) / 2
Return on assets, or ROA, is another profitability ratio, similar to ROE, which is measured by dividing net profit by the company’s average assets. It’s an indicator of how well the company is managing its available resources and assets to net higher profits.
ROA = Net Profit / (Beginning Total Assets + Ending Total Assets) / 2
Operating cash flow is a measure of how much cash the business has as a result of its operations. This measure could be positive, meaning cash is available to grow operations, or negative, meaning additional financing would be required to maintain current operations. The operating cash flow is usually found on the cash flow statement and can be calculated using one of two methods: direct or indirect.
Seasonality is a measure of how the period of the year is affecting your company’s financial numbers and outcomes. If you’re in an industry that’s affected by high and low seasons, this measure will help you sort out confounding variables and see the numbers for what they truly are.
It’s important to note there’s no absolute good or bad when it comes to financial KPIs. Metrics need to be compared to prior years or competitors in the industry to see whether your company’s financial performance is improving or declining and how it’s performing relative to others.
There are many other financial KPIs you can track and monitor to understand how your company is doing and how your actions impact progress toward shared goals. The financial KPIs listed above are a great place to start if you’re unfamiliar with finance. Understanding how these metrics influence business strategy is a critical financial accounting skill for all managers to develop.
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