We are taught that our most important measurement in business is the profit or loss that we have at the end of the year. Many of us work for an entire year before we know what that number is. And, once we find out what our profit or loss is, we then put the report away and never look at it again.
If we spend a little more time with our financial reports, we might look at our balance sheet. We often don't understand what the different numbers mean and then put that report away also.
I believe the main reason we don't use our financial reports in a meaningful manner are the following reasons:
- We don't understand how to read our basic financial reports.
- Our financial reports don't come to us in a timely manner.
- We don't share our financial information with anyone in the company (as if the others in our company would have any better understanding of our numbers than we do, right?).
- We don't make the financial reports a roadmap for how we can measure our company performance, and we don't work with key areas of our company that drive the important numbers on our financial statements.
- We don't understand why our basic financial reports are the raw information needed for knowing what the drivers are that influence the financial return our business provides.
Enter key performance indicators
Key performance indicators are the two or three numbers from our financial reports (profit and loss statement, balance sheet and cash flow statements) that spell the difference between success and failure. These numbers are often not the ones we look at first when we review our reports.
Key performance indicators are often numbers that we don't understand because we don't know which numbers are key and which numbers are not key on our financial statements. The key numbers are the measurements that can easily help us significantly improve the financial, service or efficiency in our companies.
Working with a key performance indicator (KPI) allows you to understand what the drivers are in your business to make your business better. For example, in some businesses knowing not only how much inventory you have on hand, but how long it takes to sell your inventory might be a key performance indicator. For others, the amount of cash your business has on hand can be a key performance indicator. And, still for another business a key performance indicator might be gross profit that the business produces.
The important thing to remember when thinking about the concept of a key performance indicator is to know which three or four numbers in your financial reporting package tell you show successful your company has been. Once you figure out which numbers are important, we can then move to the second step, what drives those key performance indicators in a positive or negative direction.
Drivers, the breakfast of champions.
Understanding what KPIs are important in your business is a good start. To make good use of your new understanding of KPIs you must know what the drivers are for those KPIs. To improve your business, you must not only measure what your key performance indicators are, you must also know actions will improve those key performance indicators.
For example, if we have inventory turns as a key performance indicator, it's important to know how often it takes us to sell the inventory we have on hand. If it takes us four months to sell our inventory and we have $500,000 of inventory on hand, then we will cycle through this inventory four times per year.
If we believe that we can improve our inventory turns from four times per year to eight times per year, we'll end up creating $250,000 of cash. This can be found money, but first we need to understand what specific actions in our company cause us to have $500,000 in inventory. Are there things we can measure or do that will help us increase how fast we turn our inventory? Or, to put it another way, are there things we can do to decrease the amount of inventory we need to keep on hand?