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Understanding financial ratios
Dirty little start-up Secret #14

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

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WHY
RATIOS HELP YOU COMPARE
you know, like…

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WHY
RATIOS HELP YOU COMPARE
you know, like…
how much money do I have in the bank today?

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WHY
RATIOS HELP YOU COMPARE
you know, like…
how much money do I have in the bank today?
what are my operating expenses each month?

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WHY
RATIOS HELP YOU COMPARE
you 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?

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WHY
RATIOS HELP YOU COMPARE
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

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WHY
RATIOS HELP YOU COMPARE
let’s look at revenue by month as an example
what does that absolute number tell you?

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WHY
RATIOS HELP YOU COMPARE
pretty much just that . what is your revenue

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WHY
RATIOS HELP YOU COMPARE
but it does not tell you if that is…‘good’

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WHY
RATIOS HELP YOU COMPARE
that’s where ratios come in

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WHY
RATIOS HELP YOU COMPARE
but let’s look at a concrete example

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WHY
RATIOS HELP YOU COMPARE
here is a hypothetical business that makes concrete for buildings

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WHY
RATIOS HELP YOU COMPARE
you happy with that as a founder? do you understand your business?

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WHY
RATIOS HELP YOU COMPARE
not really

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WHY
RATIOS HELP YOU COMPARE
what if I add this bit of detail?
wow! what an amazing business right? look at that steadily increasing profit!

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WHY
RATIOS HELP YOU COMPARE
but, can you see the problem?

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WHY
RATIOS HELP YOU COMPARE
this business is making money now, but it cannot scale

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WHY
RATIOS HELP YOU COMPARE
you can see this clear as day if you consider the most basic Ratio:
Profit Margin

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

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WHY
RATIOS HELP YOU COMPARE
now look again
oh dear. margin is shrinking quickly!

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WHY
RATIOS HELP YOU COMPARE
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!

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WHY
RATIOS HELP YOU COMPARE
why?!?

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WHY
RATIOS HELP YOU COMPARE
why is your margin shrinking?
is it revenue?

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

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WHY
RATIOS HELP YOU COMPARE
hmmmm, despite a margin crisis, sales growth is actually improving over time
kudos to your sales team

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WHY
RATIOS HELP YOU COMPARE
so if it is not revenue that is pulling down your profitability, it must be cost

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WHY
RATIOS HELP YOU COMPARE
let’s look at the Operating Expense Ratio which is calculated as:
operating expenses / revenue

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WHY
RATIOS HELP YOU COMPARE
a-ha. something is stinky!
your costs are growing out of control

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WHY
RATIOS HELP YOU COMPARE
do we need to fire the plant manager?
are we somehow exposed to some raw materials cost fluctuations?

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

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WHY
RATIOS HELP YOU COMPARE
uh…were we too quick to congratulate sales?

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WHY
RATIOS HELP YOU COMPARE
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

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WHY
RATIOS HELP YOU COMPARE
but they’re useful for one other thing as well

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WHY
RATIOS HELP YOU COMPARE
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

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WHY
RATIOS HELP YOU COMPARE
why are we so good relatively? what is so unique about our business model and what does that mean for the future?

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WHY
RATIOS HELP YOU COMPARE
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

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WHY
RATIOS HELP YOU COMPARE
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

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liquidity ratios tell you how much of your current assets can be used to meet short-term creditor claims
APPENDIX
Liquidity Ratios!

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how efficient is a firm at using its assets to generate revenue
APPENDIX
Activity Ratios!

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what % of a firm’s assets are financed with creditor dollars (how much is owned by bank vs shareholders)
APPENDIX
Leverage Ratios!

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how well are we doing
APPENDIX
Profitability Ratios!

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used to compare firms in a similar industry
APPENDIX
Market Ratios!

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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

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