Aside from having a great product, good sales, good SEO, great marketing, etc., there is one thing that is vital to a startup’s long-term growth and success: good accounting.
And yes… you may not be as versed in numbers as your accountant. But understand: a working knowledge of an income statement, balance sheet, and cash flow statement is essential.
And along with that, a working knowledge of key financial ratios.
And if you understand these ratios, you will become a better entrepreneur, steward, company to buy, and yes…investor.
Because YOU will know what to look for in an upcoming company.
Here are the key financial ratios every startup should:
1. Working Capital Ratio
This ratio indicates whether a company has enough assets to cover its debts.
The ratio is Current Assets/Current Liabilities.
(Note: current assets refer to those assets that can be converted into cash within a year, while current liabilities refer to those debts that are due within a year)
Anything below 1 indicates negative W/C (working capital). While any value greater than 2 means the company is not overinvesting assets; A ratio between 1.2 and 2.0 is sufficient.
Therefore, Papa Pizza, LLC has current assets of $4,615 and current liabilities of $3,003. Your current ratio would be 1.54:
($4,615/$3,003) = 1.54
2. Debt to equity ratio
This is a measure of a company’s total financial leverage. It is calculated by Total Liabilities/Total Assets.
(Can be applied to both personal and corporate financial statements)
David’s Glasses, LP has total liabilities of $100.00 and equity is $20,000, the debt to equity ratio would be 5:
($100,000/$20,000)= 5
It depends on the industry, but a ratio of 0 to 1.5 would be considered good, while anything above that… not so good!
Right now, David has $5 of debt for every $1 of equity… he needs to clean up his balance sheet fast!
3. Gross profit margin ratio
This shows the financial health of a business to show revenue after cost of goods sold (COGS) is deducted.
It is calculated as:
Revenue–COGS/Revenue=Gross Profit Margin
Let’s use a larger company as an example this time:
DEF, LLC earned $20 million in revenue and incurred $10 million in expenses related to COGS, so the gross profit margin would be %50:
$20 million-$10 million/$20 million=.5 or %50
This means that for every $1 earned you have 50 cents in gross earnings… not bad!
4. Net profit margin ratio
This shows how much the company made in TOTAL profit for every $1 it generates in sales.
It is calculated as:
Net Income/Revenue=Net Profit
Therefore, Mikey’s Bakery made a net profit of $97,500 on revenue of $500,000, so the net profit margin is %19.5:
$97,500 Net Profit $500,000 Revenue = 0.195 or %19.5 Net Profit Margin
For the record: I excluded operating margin as a key financial ratio. It is an excellent ratio as it is used to measure a company’s pricing strategy and operating efficiency. But just excluding it doesn’t mean you can’t use it as a key financial ratio.
5. Accounts receivable turnover ratio
Accounting measure used to quantify the efficiency of a company in the granting of credit and in the collection of debts; In addition, it is used to measure the efficiency with which a company uses its assets.
It is calculated as:
Sales/Accounts Receivable = Accounts Receivable Turnover
Therefore, Dan’s Tires, made about $321,000 in sales, has $5,000 in accounts receivable, so the accounts receivable turnover is 64.2:
$321,000/$5,000=64.2
So this means that for every dollar invested in accounts receivable, $64.20 is returned to the company in sales.
Good job Dan!!
6. ROI ratio
A performance measure used to assess the efficiency of an investment for comparison with other investments.
It is calculated as:
Investment Gain-Investment Cost/Investment Cost=Investment Return
So Hampton Media decides to fork out a new marketing program. The new program cost $20,000 but is expected to generate $70,000 in additional revenue:
$70,000-$20,000/$20,000=2.5 or 250%
Therefore, the company is looking for a 250% return on its investment. If they come close to that… they’ll be happy campers 🙂
7. Return on capital ratio
This ratio measures how profitable a company is with the money shareholders have invested. Also known as “return on new value” (RONW).
It is calculated as:
Net Income/Shareholders’ Equity=Return on Equity
ABC Corp shareholders want to see HOW well management is using invested capital. So, after reviewing the books for fiscal 2009, they see that the company made $36,547 in net income on the $200,000 they invested to earn an 18% return:
$36,547/$200,000= 0.1827 or 18.27%
They like what they see.
Your money is safe and you’re making a pretty solid return.
But what are your thoughts?
Are there other key financial ratios I missed?