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Common Financial Metrics Used in Organizations

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

There are many financial metrics managers and investors can use to understand the financial health of an organization. In this lesson, we'll learn some of the most common metrics that most people in an organization can use and understand.

The Role of Financial Metrics

Financial metrics are quantitative measures that business managers and analysts can use to assess the performance of their business. They can be of most use to those who have jobs in finance and accounting, but they are important for everyone to understand because they tell us about the financial health of a company. Investors will demand to know them. Employees should be interested in them, and managers will use them to hold themselves and everyone else accountable.

In fact, one of the benefits of financial metrics is to make sure that everyone understands how their job and department impacts those financial metrics. When someone has ownership for a key part of a financial metric that they know will be seen by others, they put a lot of effort into making sure their numbers look good.

The metrics we'll talk about is this lesson does not represent a complete list. But we will discuss some that are common and fairly simple.We are going to go over four important financial metrics: return on investment (ROI), internal rate of return (IRR), cost per hire, and the net profit margin.

Return on Investment

The return on investment (ROI) isn't usually calculated as a financial metric based on the entire company; although, it can be. It is best used to evaluate the return on the investment in a project.

For example, if a company is considering building a $1,000,000 production line for a product that will sell $300,000 per year for five years, then that $1 million investment will generate $1.5 million in sales ($300,000 * 5 years).

Here's the formula for ROI, which we'll talk through in the next paragraph:

ROI

Of that $1.5 million, only $500,000 is profit, and since the investment was $1 million, that's a 50% return. BUT, don't forget that it is measured over five years. If we want to turn that into an annual return, we need to divide it by the appropriate number of years. So, 50% divided by the 5 years the production line was used is 10% per year. The company's investment had a ROI of 10%.

Internal Rate of Return

Like the ROI, the internal rate of return (IRR) is an internal financial metric that managers can use to compare the financial payoff of different projects or investments. The IRR formula discounts the future cash flows of an investment to make the net present value equal to zero. To do that, you need to assume a discount rate at which the cash flows are discounted. The higher that rate, the better the investment.

While there is a formula for IRR, it's for theoretical purposes, not to use in actually calculating IRR. Calculating IRR requires some basic data analysis software, like Excel. If you use Excel, you simply use the =IRR() function; the only input required is the future stream of cash flows. The only thing you need to remember, no matter what data analysis package you use, is that your 'year 0' cash flow (which means now) is a negative number - the total amount you need to invest now. When you use Excel, all it is doing is taking the cash flow from year 1, discounting it at the necessary rate to make the present value zero, and doing that for the entire useful life of the project. The project with the highest discount rate is the most profitable.

Net Profit Margin

The net profit margin is one of the most basic financial metrics used in business - both by internal managers and external investors. Simply defined, the net profit margin is the percent of revenue generated that is not used to pay for the cost of goods or services and some portion of overhead costs. The formula is quite simple:

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