Owners who don’t understand basic accounting operate at a MAJOR disadvantage.

But thankfully, you don’t need to know it all to avoid ruin.

Here are the 5 accounting KPIs you need to know to get started:

1. Gross Profit Margin

2. Working Capital Ratio

3. Accounts Receivables Turnover

4. Accounts Payables Turnover

5. Inventory Turnover

We’ll talk through each of these in a minute.

Gross Profit Margin

Gross Profit Margin (GPM) = (Revenue-Cost of Goods Sold (COGS)) / Revenue

Both Revenue and COGS can be found on the Income Statement.

GPM indicates the efficiency with which a business turns its revenue into profit. Stable gross margins show that a business’s cash flows are stable. It can also be used to compare business models within the same industry. The reason for this is that players in the same industry tend to convert their assets into revenue at comparable rates.

As an owner, GPM is one of the key metrics you can use to identify areas for Revenue growth and cost cutting. A quick way to do this is by increasing prices, but you’ll want to proceed carefully to avoid alienating customers.

However, if low margins are due to an unreasonably high Cost of Goods Sold (COGS) and your competitors can deliver similar quality for a lower price, then you’re better off cost cutting in order to avoid losing market share and falling further behind on GPM.

Another way to increase Gross Profit Margin is to increase the average order value (AOV) of your existing customer base.

In short, a high Gross Profit Margin indicates efficient operations while a comparatively low result warrants a second look.

An important note here is that GPM reflects profit made before deducting SG&A. Subtracting these expenses will leave you with the net profit margin.

Working Capital Ratio

Working Capital Ratio = Current Assets / Current Liabilities

A business’s working capital ratio describes its ability to meet short-term debt obligations. Every SMB should be tracking to and managing its working capital regularly as liquidity issues will dramatically increase its risk of going bankrupt—no matter how promising its future growth potential may appear.

Note that this ratio is also referred to as the Current Ratio.

A ratio of less than 1 indicates liquidity issues—either at present or in the very near future. Between 1.5 and 2 shows stable liquidity. A ratio over 2 signals inefficient asset allocation. In other words, if your Working Capital Ratio falls sits significantly above 2, you could do a better job of using your assets to generate additional revenue.

You’ll need to review your result in context though. Part of the reason for this is that this ratio only reflects your SMB’s ability to satisfy its liabilities in the event of a total liquidation of asses—which is an exceedingly rare event. It does not take into account additional financing you may have secured.

One particularly helpful way to use this KPI is to study it over time to rule out emergent cash collection issues. Doing so gives you time to adjust your credit policy and follow up on outstanding accounts as needed. A poor working capital ratio might also prompt you to revisit your inventory turnover, which we will discuss later.

You can calculate the Working Capital Ratio from the Balance Sheet.

Accounts Receivables Turnover

Accounts Receivables Turnover = Net Credit Sales / Avg. Accounts Receivables

This ratio tells you your rate of cash collection from customers. Be careful to only use true credit sales in your calculation here as using total sales will inflate your result.

In simple terms, this ratio spits out the number of times your receivables are converted to cash in a given time period. Often, you’ll see this calculated on a monthly, quarterly, and annual basis.

Tracking your A/R turnover over time can also help you improve your collection practices, as well as be more selective about who you extend credit to in the first place.

Generally speaking, a higher ratio is better, but there are a few caveats.

• Companies that operate on a cash basis will have a higher ratio

• Having a conservative credit policy in place minimizes risk and drives up your result here, but it can drive away potential clients

A/R can be found under Current Assets on your Balance Sheet.

Before we move on though, there are a few less obvious reasons that you’ll want to maximize your Receivables Turnover Ratio.

Besides helping your business to get capital on hand faster through a more efficient collections process and to avoid writing off bad debt, a strong A/R Turnover ratio also:

• Gives you increased collateral opportunities: Some lenders use A/R as collateral, allowing the business to borrow more funds if needed

• Allow you to project future inflows with greater accuracy, leading to more strategic capital allocation

Accounts Payables Turnover

Accounts Payables Turnover = Total Supplier Purchases / Avg. Accounts Payable

This ratio tells you the rate of cash payment to suppliers.

Ideally, it should be less than the rate at which your business is collecting cash (A/R Turnover). Additionally, you don’t want it so fast that you’re missing out on other uses for that cash (potential investments).

Like A/R Turnover, you can use this ratio to be sure that you have enough cash to meet short-term obligations. Tracking and optimizing this KPI also puts you in a stronger position to obtain financing as needed.

But as with the KPIs already discussed, you’ll want to study your result in context.

A decreasing ratio over time could indicate financial distress, but it could also come as a result of negotiating more favorable payment terms with your suppliers. On the other hand, an increasing ratio over time could indicate healthy cash flow, but it could also be a sign that the company is failing to adequately reinvest for growth.

A/P appears on the Balance Sheet under Current Liabilities.

Inventory Turnover

Inventory Turnover = COGS / Average Inventory Balance

Inventory Turnover tells you the rate at which inventory is sold and replaced in a given period. A low value here might indicate weak sales, or that you’re holding too much inventory. On the other hand, too high a turnover could signal a problem with frequent stock-outs, leading to lost sales.

If you want to know the average number of days it takes the business to sell its inventory, divide the number of days in the period by your inventory turnover over that same period.

One of the primary uses for this KPI is to help you make pricing decisions, but it can also be used to guide your purchasing, manufacturing, and marketing decisions.

For instance, a well targeted marketing campaign may boost low inventory turnover without having to slash prices just to move stock. In addition, this KPI can be tracked at the SKU level, allowing you to prioritize the fastest moving items in production and limit runs of dead stock.

If you need help tracking these KPIs for your business or have any questions, feel free to reach out.

As always, I’m happy to help.

Putting It All Together

Here are your top takeaways from this week’s post.

1. Owners who don’t know basic accounting operate at a major disadvantage. Fortunately, you don’t need to know it all.

2. Tracking these 5 KPIs will get you pretty far:

   1. Gross Profit Margin (GPM) = (Revenue-Cost of Goods Sold (COGS)) / Revenue

   2. Working Capital Ratio = Current Assets / Current Liabilities

   3. Accounts Receivables Turnover = Net Credit Sales / Avg. Accounts Receivables

   4. Accounts Payables Turnover = Total Supplier Purchases / Avg. Accounts Payable

   5. Inventory Turnover = COGS / Average Inventory Balance

3. GPM can be calculated from the Income Statement while the other four come from the Balance Sheet.

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‘Til Next Time,

Connor