Leading indicators must lead to financial results. If they don’t then they are not good leading indicators. It’s that simple.
Before we go deeper and discuss why this is simple, though not always easy nor used, let’s look at what a leading indicator is versus a lagging indicator.
A leading indicator is any measure that predicts future results. Leading indicators in a company may be things like number of new orders received, number of repeat customers, or number of potential orders in the pipeline. For some companies, leading indicators may occur outside their business and be things like growth in GDP, number of new housing starts, and changes in the price of gas.
A lagging indicator is any measure that tells you what has already occurred. The most common example of a lagging indicator is a company’s financial results. In fact, all indicators, both leading and lagging, must eventually materialize in the financial results. If they don’t, they are not reliable nor useful, so go find a better indicator to measure.
In order for a leading indicator to be reliable, it must be proven that when the leading indicator changes, there is a corresponding change in financial results. For example, when the number of new orders received increases, so does revenues. There may be, and in fact, usually is a delay between the leading indicator and the lagging one – thus their names. However, inevitably, one must follow the other.
The problem that many small business owners experience is that they don’t adequately track their financial results, which are a key lagging indicator. Some small business owners use the shoe box method, which means they have no idea of how their business performed until tax time. Others may have QuickBooks or other software set up, but are sporadic at best at inputting data. Many may track their data but have inadequate reporting set up or don’t understand how to read their financial reports so they ignore them.
For example, I heard about one small business that had an outdated accounting system and an untrained bookkeeper. As a result, many of the checks that had been issued were not actually entered into the accounting software. Just a hint, any measure that lacks full information is useless. I would like to say that this sort of thing rarely occurs. Unfortunately, I know better. I, personally, have fixed more messed up financial systems than I care to think about. And I’m sure that the ones I saw are just the tip of the iceberg.
So here is the take away – Every company needs both reliable leading and lagging indicators. The leading indicators should be tested against financial results to prove that they truly do indicate future performance. And if you have only one lagging indicator, make sure that it is financial reports that accurately reflect the performance of the company and provide information that is understandable and usable.
Take a look at the things you measure today. Are they leading or lagging indicators? Ideally you should have some of both.
