Key Performance Indicators

By October 2, 2018Financial Reporting
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Key performance indicators (KPIs) are both a powerful tool that management can use in evaluating the performance of your company and a key part of the Management Discussion and Analysis (MD&A) section of your company’s Form S-1. Effective KPIs are critical in your efforts to offer valuable insights to current stakeholders and potential investors that will increase the attractiveness of your company. However, choosing and accurately reporting KPIs can be a significant difficulty for pre-IPO companies.

This article will explain the different types of KPIs, qualities to consider in your selection of KPIs, and considerations for reporting your KPIs in the MD&A section of your Form S-1.

Types of KPIs

Other common names for KPIs are key success indicators, key metrics, key variables, key measures, and performance metrics. While the names may vary, they all refer to quantifiable variables used to measure a company’s performance. KPIs help companies and investors measure progress toward financial and strategic goals, especially in comparison to other companies in the same industry.

GAAP Financial Measures

Generally accepted accounting principles (GAAP) financial measures are those that are already available on the face of the financial statements, or that can be calculated using GAAP financial data. Such measures could include traditional financial ratios such as gross margin or the current ratio if those measures are key to management’s strategy.

One of the advantages of GAAP measures is comparability. Because GAAP measures are calculated according to common rules set by the Financial Accounting Standards Board (FASB), there is less variation in how the numbers are reported across companies. However, while GAAP financial results are important measures for financial statement users, non-GAAP measures and non-financial measures are often considered to be even more important.

Non-GAAP Financial Measures

Your company may elect to use non-GAAP measures as KPIs in your MD&A. Using non-GAAP measures such as EBITDA (earnings before interest, taxes, depreciation, and amortization) is a common practice, but has specific SEC reporting requirements designed to increase the transparency of those measures. For a more complete discussion of these requirements, please see our article Non-GAAP Financial Measures.

Non-financial Measures

Non-financial KPIs are often industry-specific and can include measures such as daily active users (DAUs) for apps or websites, same-store sales for a retailer, or barrels of oil produced for an oil company. Non-financial measures can also include macroeconomic data that has a significant effect on company performance. In many industries, investors follow non-financial KPIs even more closely than financial data.

How to Select KPIs

When selecting KPIs, your company should consider qualities such as usage in your industry, the relationship to your strategy, reliability, stability, and costs.

Industry-specific Metrics

In many industries, investors expect companies to report certain industry-specific KPIs in the MD&A to increase comparability within the industry. In fact, some industry groups create standardized definitions for KPIs. You should see if these definitions exist for your industry and review the filings of your competitors to identify widely used KPIs that you can include in your own financial statements. Neglecting to report on standard industry KPIs could send a negative message to investors; therefore, it is critical to identify and measure those metrics early on.

Relationship to Strategy

Because the MD&A is meant to give investors insight into how your company is being managed, KPIs should effectively communicate your company’s strategic direction. PwC’s Guide to Key Performance Indicators states that “the primary reason for including performance indicators in corporate reporting is to enable readers to assess the strategies adopted by the company and their potential to succeed.” Therefore, you should be careful to select indicators that will most clearly represent how successfully your company achieved its strategic and operational goals. If you select a KPI that does not truly represent strategic success, then it will not be of value to investors, and could even send the wrong message about your success.

It’s never too early to begin considering what KPIs are most indicative of your company’s performance. Understanding what metrics drive growth will help you manage your company and focus on activities that most profoundly impact your strategy. In addition, investors will use these KPIs to predict future performance; therefore, taking sufficient time and effort soon after starting your company will help ensure that you are measuring and reporting the most beneficial measures. Identifying these key metrics early on will increase your ability to effectively measure and report them once you file your S-1 and can also help you focus on the aspects that are most relevant to your company’s strategy.

Your competitors’ financial filings, third-party analyst reports, and industry experts are excellent resources that can help you identify the KPIs that are important to the strategic success of companies in your industry. These resources can help your company begin to select and report KPIs.

Reliability

You should ensure that your KPIs can be reliably and consistently measured. PwC’s Guide to Executing a Successful IPO counsels: “If using non-financial KPIs, consideration should be given to how robust and consistent the data is as it will need to stand up to legal verification for a public process.” Therefore, if a KPI is not being measured reliably, then you should either (1) exclude it from the S-1 or (2) improve the controls and processes surrounding it.

During the pre-IPO process, your company will focus on creating and improving controls over financial reporting to improve the accuracy of your financial statements, increase the efficiency in monthly close processes, and prepare for an audit of internal controls over financial reporting. Your company should take a similar level of care in creating controls and processes for measuring and reporting KPIs. Because of the complexity involved in aggregating KPI data, you should design controls that validate the completeness and accuracy of the KPIs. These controls will increase reliability and decrease the cost of compiling KPIs. Your auditors will also need to provide assurance that the KPIs you report are materially consistent with your financial statements. Adequate controls will help the audit run more smoothly by ensuring that your KPIs are materially accurate.

Stability

Selecting KPIs that are relatively stable over time can help your company avoid negative stock market reactions that might occur in response to changes in your KPIs. Investors can react negatively to large volatility in your KPIs even if you report strong earnings. Analysts will often expect KPIs to continue increasing at a rate consistent with past rates of increase. For this reason, missing these estimates can have a negative impact on your post-IPO share price. While volatile KPIs cannot be entirely avoided, selecting stable indicators is one way to avoid some of these concerns.

For example, Snapchat’s daily active users (DAUs) growth rate has been unstable and lower than expected since their IPO in March of 2017. Figure 2 below shows that Snapchat’s DAU quarter over quarter growth rate was negative for the first time in Q2 2018.

Despite beating earnings estimates in Q2 2018 by 4 cents, Snapchat’s stock price suffered because of the decrease in DAUs. The day after announcing its Q2 2018 earnings, Snapchat was trading at $12.23, down from $13.05 the day before the earnings announcement. Although other factors contributed to this 6.28% decrease in share price (and more than a 50% decrease in the company’s stock since its IPO), the volatility of DAUs has been a major concern to investors. Snapchat may have been better off following the lead of Facebook and Twitter by reporting monthly active users (MAUs) instead of DAUs. This change likely would have increased the stability of Snapchat’s KPI and prevented some investor concern.

Costs

While KPIs provide valuable information to management and investors, the costs of tracking and reporting certain KPIs may outweigh the benefits, especially for smaller companies. Creating a system that accurately captures KPI data can be time consuming and costly, so you should open a dialogue with investors to determine which metrics would be most useful for them, and then consider whether those benefits outweigh the costs of tracking the KPI.

Additionally, publicly reporting KPIs can reveal valuable information to competitors. Before reporting a KPI, you should consider how it could impact your competitive advantage and determine if this effect outweighs the benefits of providing investors with more information.

MD&A Reporting Considerations

The SEC strongly encourages companies to report KPIs. Topic 9 of the SEC financial reporting manual states that “registrants may find it helpful to include a discussion of key variables and financial measures management is utilizing in managing the business.” Additionally, KPIs are a valuable source of information that can help your company effectively market your shares to investors. Therefore, while KPIs are not expressly required, excluding them from your financial statements could send a negative signal to the market, indicating that your KPIs are subpar.

KPIs are generally included in the “Results of Operations” section of the MD&A. According to SEC Rules Interpretation 33-8350, the purpose of the MD&A is “to give readers a view of the company through the eyes of management by providing both a short and long-term analysis of the business.” If appropriate KPIs have been selected and are reported effectively, they will play an important role in accomplishing that purpose.

Link to Strategy and Performance

In your presentation of KPIs, you should clearly state how they relate to your strategy and performance so that investors can clearly understand why your chosen KPIs are relevant. For example, Facebook included the following explanation of its KPIs in its 2012 S-1:

Growth trends in MAUs, DAUs, and mobile MAUs are critical variables that affect our revenue and financial results by influencing the number of ads we are able to show, the value of those ads, the volume of Payments transactions, as well as our expenses and capital expenditures.

By directly linking the KPIs to financial results at the very beginning of the discussion on KPIs, Facebook highlights why these measures are important to their strategy and performance. Remember that because the MD&A is meant to give investors a look at the company “through the eyes of management,” you should discuss why your selected KPIs are important to you in managing your company.

Definitions

Because KPIs are often specific to your company, a definition of each KPI should be included in your disclosure. SEC rules interpretation 33-8350 states that companies “should provide an explanation of its calculation to promote comparability across companies within the industry.” Some KPIs may seem self-explanatory; however, they can often be calculated differently by different companies. Therefore, it is important to make sure that investors have a clear definition of your KPIs by providing explanations about how the KPI is calculated and discussing any issues that could affect KPI measurement.

You may also need to educate investors about your KPIs beyond the definition included in your financial statements. If investors do not understand the connection between a KPI and company performance, then reporting the metric will be of little use to them. To avoid this issue, your company should communicate with investors to make sure that they understand the metric and its relationship to performance. Additionally, if there are any changes in the way that KPIs are measured, then management should explain those changes in the MD&A and in other communications to investors to ensure comparability with past financial statements.

Non-GAAP KPIs have special reporting requirements, such as reconciling the Non-GAAP value to a GAAP value. These requirements are discussed more thoroughly in our Non-GAAP Financial Measures article.

Changes and Trends

KPIs for a single period are not particularly useful in evaluating changes in your company’s performance; therefore, you should report and discuss changes and trends in KPIs. You might consider including a graphic to aid investors in visualizing KPI trends. You should also explain how the trends will affect your financial performance and what management intends to do to address such trends. Additionally, you may choose to provide an expectation of future growth for each KPI.

Segment Reporting

If your company operates in various industries or has multiple divisions, then your KPIs may need to be segmented. Because the strategies of your various divisions will probably differ, KPIs that are disaggregated by operating segment are more useful to investors and decision makers.

If KPIs are more relevant on a segmental level, then they should be disaggregated accordingly. For example, Berkshire Hathaway reports KPIs that are specific to its various subsidiaries to provide information specific to those industries. For more information on segment reporting, please see our article Segment Reporting.

Retiring KPIs

As your company evolves, certain KPIs may become less relevant to your company’s strategy and performance, and you may want to stop reporting them. However, because investors will expect you to continue to report past KPIs, you should be very careful when deciding to retire a KPI. If you do decide to retire a KPI, then you should explain why the KPI was retired, focusing on why it is no longer a relevant measure of your performance. Keep in mind that even after careful communication with investors, retiring a KPI could negatively affect your stock price.

Conclusion

Key performance indicators are an effective method for communicating your company’s performance to investors. As your company chooses KPIs, you should understand how those KPIs will relate to your strategy and consider their reliability, stability, comparability, and cost. When reporting KPIs, your company should communicate how the KPIs relate to your company’s strategy, define each KPI, and include an analysis of any KPI trends. Companies should also consider if segment reporting is appropriate and reevaluate the relevance of former KPIs. In addition to reporting, KPIs can aid your company in measuring performance and focusing on key drivers of growth.
 


 
 


 

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Author Rand Hawk

Rand is from Gilbert, AZ and will graduate with a MAcc from BYU in April 2019. He is currently studying to become a CMA and CPA. Rand is a huge Cubs fan and enjoys spending time with his wife and son.

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