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Understanding financial ratios

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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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SHARE THIS DECK & FOLLOW ME (please-oh-please-oh-please-oh-please) stay up to date with my future slideshare posts http://www.slideshare.net/selenasol/presentations https://twitter.com/eric_tachibana http://www.linkedin.com/pub/eric-tachibana/0/33/b53 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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