UNDERSTANDING FINANCIAL RATIOS

DIRTY LITTLE START-UP SECRET #14

WHYRATIOS HELP YOU COMPAREas a start-up founder, it is important to

know the absolute numbers of your business

WHYRATIOS HELP YOU COMPAREyou know, like…

WHYRATIOS HELP YOU COMPAREyou know, like…

how much money do I have in the bank

today?

WHYRATIOS HELP YOU COMPAREyou know, like…

how much money do I have in the bank

today? what are my operating expenses each

month?

WHYRATIOS HELP YOU COMPAREyou know, like…

how much money do I have in the bank

today? what are my operating expenses each

month?how much cash can I expect to come in

next week?

WHYRATIOS HELP YOU COMPAREbut, 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

WHYRATIOS HELP YOU COMPARElet’s look at revenue by month as an

example

what does that absolute number tell you?

WHYRATIOS HELP YOU COMPAREpretty much just that . what is your

revenue

WHYRATIOS HELP YOU COMPAREbut it does not tell you if that is…‘good’

WHYRATIOS HELP YOU COMPAREthat’s where ratios come in

WHYRATIOS HELP YOU COMPAREbut let’s look at a concrete example

WHYRATIOS HELP YOU COMPAREhere is a hypothetical business that

makes concrete for buildingsConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 200,000 250,000 330,000 600,000 1,100,000

WHYRATIOS HELP YOU COMPAREyou happy with that as a founder? do

you understand your business?

WHYRATIOS HELP YOU COMPAREnot really

WHYRATIOS HELP YOU COMPAREwhat if I add this bit of detail?

wow! what an amazing business right? look at that steadily increasing profit!

ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

WHYRATIOS HELP YOU COMPAREbut, can you see the problem?

WHYRATIOS HELP YOU COMPAREthis business is making money now,

but it cannot scale

WHYRATIOS HELP YOU COMPAREyou can see this clear as day if you

consider the most basic Ratio:

Profit Margin

WHYRATIOS HELP YOU COMPAREprofit margin is calculated as:

net profit / sales

it tells you how much money you make for every $1 in sales

WHYRATIOS HELP YOU COMPAREnow look again

oh dear. margin is shrinking quickly!

ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

Profit Margin .70 .62 .55 .47 .37

WHYRATIOS HELP YOU COMPAREwhere 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!

ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

Profit Margin .70 .62 .55 .47 .37

WHYRATIOS HELP YOU COMPAREwhy?!?

WHYRATIOS HELP YOU COMPAREwhy is your margin shrinking?

is it revenue?

WHYRATIOS HELP YOU COMPAREwe can check out the Sales Growth

Ratio which is calculated as:

(current period sales – previous period sales) / previous period sales

WHYRATIOS HELP YOU COMPAREhmmmm, despite a margin crisis, sales

growth is actually improving over timekudos to your sales team

ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

Profit Margin .70 .62 .55 .47 .37

Sales Growth .25 .32 .82 .83

WHYRATIOS HELP YOU COMPAREso if it is not revenue that is pulling

down your profitability, it must be cost

WHYRATIOS HELP YOU COMPARElet’s look at the Operating Expense

Ratio which is calculated as:

operating expenses / revenue

WHYRATIOS HELP YOU COMPAREa-ha. something is stinky!

your costs are growing out of control

ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

Profit Margin .70 .62 .55 .47 .37

Sales Growth .25 .32 .82 .83

Operating Expenses Growth .30 .38 .45 .53 .63

WHYRATIOS HELP YOU COMPAREdo we need to fire the plant manager?

are we somehow exposed to some raw materials cost fluctuations?

WHYRATIOS HELP YOU COMPARElet’s break our cost down into 3

categories (supply, manufacturing, distribution) & compare each against

total cost

(i.e.: supply cost / total cost)

WHYRATIOS HELP YOU COMPAREuh…were we too quick to congratulate

sales?ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5Revenue 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

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

WHYRATIOS HELP YOU COMPAREso 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

WHYRATIOS HELP YOU COMPAREbut they’re useful for one other thing as

well

WHYRATIOS HELP YOU COMPAREbecause 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

WHYRATIOS HELP YOU COMPAREwhy are we so good relatively? what is so

unique about our business model and what does that mean for the future?

Quarterly Revenue Profit MarginConcreteMaster 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%

WHYRATIOS HELP YOU COMPAREyou 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

WHYRATIOS HELP YOU COMPAREplease 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 LiabilitiesQuick (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 AssetsTotal 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 AssetsTimes Interest Earned Operating income / Interest

how well are we doingAPPENDIXPROFITABILITY RATIOS!

Gross Profit Margin Gross Profit / Net SalesOperating Profit Operating Income / Net SalesNet Profit Margin Net Profit / Net SalesOperating Return on Assets

Operating income / Total Assets

Net Return on Assets Net Profit / Total AssetsReturn 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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