Financial metrics are quantitative measures used to evaluate the productivity and performance of a business. They are used both by internal managers to improve productivity and outside analysts to make decisions involving the company.
3 benefits of using financial metrics
Provide objective basis for business decisions
Business managers at all levels of a company are regularly faced with decisions. Metrics help these decision-makers base their choices on information rather than relying on intuition. Data is more likely to provide an objective basis for strategic choices and help avoid using biases and unsubstantiated rumors to run a business.
Helps compare performance with earlier time periods or outside organizations
Metrics typically take the form of ratios rather than raw data. For example, using gross revenue alone to compare two companies makes it difficult to understand how the business compares to a much larger competitor with a much higher capital investment.
Ratio analysis allows a manager to compare two pieces of information to gain insight into a specific aspect of a company’s operational performance. Ratios allow the manager to relate current performance to an earlier point in time or with a company from another industry.
Helps identify bottlenecks and waste
Experienced managers and analysts know the metrics will usually fall within a certain range. If a firm falls outside this expected range, it frequently signals a performance problem. Quickly identifying a problem and formulating a plan to address bottlenecks and waste is essential to applying lean six sigma to a project.
Why is understanding financial metrics important?
They are the language of business
Business managers and financial analysts are generally trained to use ratio analysis to evaluate a firm or project. If a manager or analyst is uncomfortable using financial metrics, they will struggle to communicate with other decision-makers in their industry.
Metrics can show whether a project or firm is a sound investment
Ratio analysis provides an objective measurement of performance in the past. This record helps an analyst or manager decide whether or not a particular course of action is likely to produce profit in the future. Without such data, a business decision-maker is reduced to guessing about future performance.
They provide a “report card” for the current status of a company
To make decisions about the future, a manager or analyst must know where the business stands at present. Relevant metrics provide this measuring stick.
Can my company meet our current obligations?
A common way to evaluate the ability of a company to meet its current obligations is to look at its current ratio. Current ratio is measured by dividing a company’s current assets by its current liabilities. For example,
- if current assets = $3,000,000
- and current liabilities = $2,000,000
- then 3,000,000/2,000,000 yields a current ratio of 1.5
A company with a larger current ratio is more likely to be able to pay its future obligations.
4 best practices when thinking about financial metrics
1. Remember that metrics only provide historical performance information
While past performance can indicate future performance, it’s not a certain indicator of what will happen. Change is something every business must take into consideration in their predictions. Nothing stays static. Many factors can affect any metric, and changed circumstances can lead to drastic shifts in outcome compared to the past.
2. Odd events can wildly skew ratios
If an odd event occurs during a performance period, it can distort an evaluation. For example, if a tornado strikes a plant and destroys a massive amount of equipment, then metrics measuring the profitability of the facility can provide a completely misleading picture regarding the performance of the manager. An accurate assessment must consider if the unexpected event is likely to reoccur.
3. Metrics are only as good as the accuracy of the measurement
If the measurements used to create the metric are inaccurate, then the ratio has little value. Inaccurate numbers are not a solid basis on which to make an evaluation. Using unsound measurements will lead to bad decisions and inefficiency.
4. Metrics must fit the process evaluated
Even if a metric is composed of accurate measurements, the numbers might be useless if they are a poor match for the things a decision-maker is attempting to evaluate. Suppose a retail firm is having problems with theft. If a company analyst tries to then compare gross profit between different locations as a measure of store manager performance, it completely fails to address how well each store is limiting shoplifting.
Frequently Asked Questions About Financial Metrics
1. How do I know the numbers are accurate?
The best way to ensure the numbers used are accurate is regular and rigorous internal auditing. Another method is to make sure to use more than one metric that addresses the process the manager is attempting to evaluate. One ratio can provide a skewed picture of a situation.
2. Where do the numbers come from?
Typically, the numbers used in ratio analysis come from either the company’s balance sheet or the income statement. These evaluation tools are produced by a bookkeeper or the accounting department in most companies.
3. What is the most important metric for a business?
For most businesses, the most important financial ratio is pre-tax profit. This ratio indicates how much money you are making on every sale. Private firms usually calculate this number by dividing net profit before taxes by sales.
Metrics are the key tool used to evaluate a business
Financial ratio analysis is an objective way to evaluate the performance of a company. While it cannot account for unexpected or unusual events, it does provide a way to quickly grasp important facts about a company and help leaders make strategic decisions based on data instead of intuition or bias.