Financial Ratios for Entrepreneurs

UNDERSTANDING
FINANCIAL RATIOS
DIRTY LITTLE START-UP SECRET #14

WHYRATIOS HELP YOU COMPARE
as a start-up founder, it is important to
know the absolute numbers of your
business

you know, like…

you know, like…
how much money do I have in the bank
today?

you know, like…
today?
what are my operating expenses each
month?

you know, like…
today?
what are my operating expenses each
month?
how much cash can I expect to come in
next week?

but, while critical to the day-to-day
operations of a business, absolute
numbers are not as useful when it
comes to strategy, where we are
concerned with trends over time &
operating efficiency

let’s look at revenue by month as an
example
what does that absolute number tell
you?

pretty much just that . what is your
revenue

but it does not tell you if that is…‘good’

that’s where ratios come in

but let’s look at a concrete example

here is a hypothetical business that
makes concrete for buildings
ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5
Revenue 200,000 250,000 330,000 600,000 1,100,000

you happy with that as a founder? do
you understand your business?

not really

what if I add this bit of detail?
wow! what an amazing business right?
look at that steadily increasing profit!
Revenue 200,000 250,000 330,000 600,000 1,100,000
Cost to Produce & Sell 60,000 95,000 150,000 320,000 690,000
Profit 140,000 155,000 180,000 280,000 410,000

but, can you see the problem?

this business is making money now,
but it cannot scale

you can see this clear as day if you
consider the most basic Ratio:
Profit Margin

profit margin is calculated as:
net profit / sales
it tells you how much money you make
for every $1 in sales

now look again
oh dear. margin is shrinking quickly!
Revenue 200,000 250,000 330,000 600,000 1,100,000
Profit 140,000 155,000 180,000 280,000 410,000
Profit Margin .70 .62 .55 .47 .37

where you were making 70 cents per
dollar of revenue in Q1, by Q5 you’re
only making .37 cents
so you’re selling more, but making less!
Revenue 200,000 250,000 330,000 600,000 1,100,000
Profit 140,000 155,000 180,000 280,000 410,000
Profit Margin .70 .62 .55 .47 .37

why?!?

why is your margin shrinking?
is it revenue?

we can check out the Sales Growth
Ratio which is calculated as:
(current period sales – previous period sales) /
previous period sales

hmmmm, despite a margin crisis, sales
growth is actually improving over time
kudos to your sales team
Revenue 200,000 250,000 330,000 600,000 1,100,000
Profit 140,000 155,000 180,000 280,000 410,000
Profit Margin .70 .62 .55 .47 .37
Sales Growth .25 .32 .82 .83

so if it is not revenue that is pulling
down your profitability, it must be cost

let’s look at the Operating Expense
Ratio which is calculated as:
operating expenses / revenue

a-ha. something is stinky!
your costs are growing out of control
Revenue 200,000 250,000 330,000 600,000 1,100,000
Profit 140,000 155,000 180,000 280,000 410,000
Profit Margin .70 .62 .55 .47 .37
Sales Growth .25 .32 .82 .83
Operating Expenses
Growth
.30 .38 .45 .53 .63

do we need to fire the plant manager?
are we somehow exposed to some raw
materials cost fluctuations?

let’s break our cost down into 3
categories (supply, manufacturing,
distribution) & compare each against
total cost
(i.e.: supply cost / total cost)

uh…were we too quick to congratulate
sales?
Revenue 200,000 250,000 330,000 600,000 1,100,000
Profit 140,000 155,000 180,000 280,000 410,000
Profit Margin .70 .62 .55 .47 .37
Sales Growth .25 .32 .82 .83
OpEx Growth .30 .38 .45 .53 .63
Supply Cost Ratio .33 .33 .33 .33 .28
Manufacture Cost Ratio .33 .33 .28 .25 .22
Selling Cost Ratio .33 .33 .39 .42 .50

so while absolute numbers are
important for day-to-day operations,
ratios are critical for strategy because
they allow you to look inwards &
monitor / investigate the efficiency of
your business over time
it allows you to identify & solve
problems

but they’re useful for one other thing as
well

because ratios remove the absolute
numbers, they can be used to compare
your business against other businesses
in your industry (even if those business
are much larger or smaller) so that you
know how well you fare relative to the
competition or can spot interesting
outliers

why are we so good relatively? what is so
unique about our business model and
what does that mean for the future?
Quarterly Revenue Profit Margin
ConcreteMaster Inc. 1,100,000 37%
DIRECT COMPETITORS
Lay It On Inc 800,000 11%
HardOn Concrete Ltd. 8,000,000 8%
CCMP 13,000,000 7%
Overall Concrete Industry Average 9%

you can actually make ratios out of any
combination of absolute numbers
depending on what aspect of your
business model you want to investigate
however, certain classic ratios have
shown great value, and your
management team should be monitoring
these monthly

please ensure that your CFO is producing
these for your monthly management
meetings and that you are reviewing them
and asking questions
i’ve dumped a bunch of classic ones in
the appendix, but feel free to create your
own depending on the nature of your
business model and its unique problems

liquidity ratios tell you how much of
your current assets can be used to
meet short-term creditor claims
APPENDIXLIQUIDITY RATIOS!
Current Current Assets / Current Liabilities
Quick (aka Acid
Test)
(Current Assets – Inventory – Prepaids) / Current
Liabilities

how efficient is a firm at using its assets
to generate revenue
APPENDIXACTIVITY RATIOS!
Inventory Turnover COGS / Average inventory at cost (where avg
inventory is (start inventory + end inventory) / 2)
Accounts Receivable
Turnover
Credit Sales / Accounts Receivable
Average Collection
Period
Days per year / Accounts Receivable Turnover
Fixed Asset Turnover Net Sales / Fixed Assets
Total Asset Turnover Net Sales / Total Assets

what % of a firm’s assets are financed
with creditor dollars (how much is
owned by bank vs shareholders)
APPENDIXLEVERAGE RATIOS!
Debt to Equity Total Liabilities / (Total Assets – Total Liabilities)
Debt to Total Asset Total Liabilities / Total Assets
Times Interest Earned Operating income / Interest

how well are we doing
APPENDIXPROFITABILITY RATIOS!
Gross Profit Margin Gross Profit / Net Sales
Operating Profit Operating Income / Net Sales
Net Profit Margin Net Profit / Net Sales
Operating Return on
Assets
Operating income / Total Assets
Net Return on Assets Net Profit / Total Assets
Return on Equity Net Profit / (Total Assets – Total Liabilities)
Sales Growth (Current Period Sales – Previous Period Sales) /
Previous Period Sales

used to compare firms in a similar
industry
APPENDIXMARKET RATIOS!
Earnings Per Share (Net Income – Preferred Dividends) / # of common
shares
Price Earnings Market Price of Stock / Earnings Per Share
Operating Cash Flow
per Share
Operating Cash Flow / Common shares of stock
outstanding

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Please note that all content & opinions
expressed in this deck are my own and don’t
necessarily represent the position of my
current, or any previous, employers

Financial Ratios for Entrepreneurs

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