Apart from having a great product, good sales, good SEO, great marketing, and so on… there is one thing that is vital to the long term growth and success of a startup: good accounting.
And yes… you may not be as versed in numbers as your accountant is. But do understand: its essential to have a working knowledge of an income statement, balance sheet, and cash flow statement.
And along with that a working knowledge of key financial ratios.
And if these ratios are understood will make you a better entrepreneur, steward, company to buy and yes…investor.
Because YOU’LL know what to look for in an upcoming company.
So 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 turned into cash within a year, while current liabilities refers to those debts that are due within a year)
Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets; A ratio between 1.2 and 2.0 is sufficient.
So Papa Pizza, LLC has current assets are $4,615 and current liabilities are $3,003. It’s 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’s calculated by Total Liabilities/Total Assets.
(It can be applied to personal financial statements as well as corporate ones)
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 over 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 a firms financial health to show revenue after Cost of Good Sold (COGS) are deducted.
It’s calculated as:
Revenue–COGS/Revenue=Gross Profit Margin
Let’s use a bigger company as an example this time:
DEF, LLC earned $20 million in revenue while incurring $10 million in COGS related expenses, so the gross profit margin would be %50:
$20 million-$10 million/ $20 million=.5 or %50
This means for every $1 earned it has 50 cents in gross profit…not to shabby!
4. Net Profit Margin Ratio
This shows how much the company made in OVERALL profit for every $1 it generates in sales.
It’s calculated as:
Net Income/Revenue=Net Profit
So Mikey’s Bakery earned $97,500 in net profit on $500,000 revenue 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 did exclude Operating Margin as a key financial ratio. It is a great ratio as it is used to measure a company’s pricing strategy and operating efficiency. But just I excluded it doesn’t mean you can’t use it as a key financial ratio.
5. Accounts Receivable Turnover Ratio
An accounting measure used to quantify a firm’s effectiveness in extending credit as well as collecting debts; also, its used to measure how efficiently a firm uses its assets.
It’s calculated as:
Sales/Accounts Receivable=Receivable Turnover
So Dan’s Tires, earned about $321,000 in sales has $5,000 in accounts receivables, so the receivable turnover is 64.2:
$321,000/$5,000=64.2
So this means that for every dollar invested in receivables, $64.20 comes back to the company in sales.
Good job Dan!!
6. Return on Investment Ratio
A performance measure used to evaluate the efficiency of an investment to compare it against other investments.
It’s calculated as:
Gain From Investment-Cost of Investment/Cost of Investment=Return on Investment
So Hampton Media decides to shell out for a new marketing program. The new program cost $20,000 but is expected to bring in $70,000 in additional revenue:
$70,000-$20,000/$20,000=2.5 or 250%
So the company is looking for a 250% return on their investment. If they get anywhere near that…they’ll be happy campers:)
7. Return on Equity Ratio
This ratio measure’s how profitable a company is with the money shareholder’s have invested. Also known as “return on new worth” (RONW).
It’s calculated as:
Net Income/Shareholder’s Equity=Return on Equity
ABC Corp’s shareholders want to see HOW well management is using capital invested. So after looking through the books for the 2009 fiscal year they see that company made $36,547 in net income with the $200,000 they invested for a return of 18%:
$36,547/$200,000= 0.1827 or 18.27%
They like what they see.
Their money’s safe and is generating a pretty solid return.
But what are your thoughts?
Are they any other key financial ratios I missed?
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