Aside from having a great product, good sales, good SEO, great marketing, etc., there is one thing that is vital to the growth and long-term success of a startup: good bookkeeping.
And yes… you may not be as versed in numbers as your accountant. But understand: It’s essential to have a working knowledge of an income statement, a balance sheet, and a statement of cash flows.
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 venture.
Here are the key financial reasons every startup should:
1. Working Capital Ratio
This ratio indicates whether a company has enough assets to cover its debts.
The relationship is Current Assets/Current Liabilities.
(Note: current assets refer to those assets that can be converted to cash within one year, while current liabilities refer to those debts that are due within one year)
Anything below 1 indicates negative W/C (working capital). While any value greater than 2 means that the company is not over-investing 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:
($4615/$3003) = 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. Ratio of gross profit margin
This shows the financial health of a company to show revenue after deducting cost of goods sold (COGS).
It is calculated as:
Revenue–COGS/Revenue=Gross Profit Margin
Let’s use a larger company as an example this time:
DEF, LLC had $20 million in revenue and incurred $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 that for every $1 earned you have 50 cents in gross profit…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/Income=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’s an excellent ratio as it is used to measure a company’s pricing strategy and operational efficiency. But just excluding it doesn’t mean you can’t use it as a key financial ratio.
5. Accounts receivable turnover rate
Accounting measure used to quantify a company’s effectiveness in granting credit and collecting debts; Furthermore, it is used to measure the efficiency with which a company uses its assets.
It is calculated as:
Sales/Accounts Receivable = Accounts Receivable Turnover
So 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 returns to the company in sales.
Good job Dan!!
6. ROI Ratio
A measure of performance used to assess the efficiency of an investment in comparison to other investments.
It is calculated as:
Investment Profit-Investment Cost/Investment Cost=Return on Investment
So Hampton Media decides to shell 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=2.5or 250%
Therefore, the company seeks a 250% return on its investment. If they come close to that… they will be happy campers 🙂
7. Ratio of return on capital
This ratio measures how profitable a company is with the money invested by shareholders. Also known as “return of 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 the invested capital. So, after reviewing the books for fiscal 2009, they see that the company earned $36,547 in net income with 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 are generating a pretty solid return.
But what are your thoughts?
Are there any other key financial ratios I missed?