financial ratios for entrepreneurs
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UNDERSTANDING FINANCIAL RATIOS
DIRTY LITTLE START-UP SECRET #14
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WHYRATIOS HELP YOU COMPAREas a start-up founder, it is important to
know the absolute numbers of your business
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WHYRATIOS HELP YOU COMPAREyou know, like…
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WHYRATIOS HELP YOU COMPAREyou know, like…
how much money do I have in the bank
today?
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WHYRATIOS HELP YOU COMPAREyou know, like…
how much money do I have in the bank
today? what are my operating expenses each
month?
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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?
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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
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WHYRATIOS HELP YOU COMPARElet’s look at revenue by month as an
example
what does that absolute number tell you?
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WHYRATIOS HELP YOU COMPAREpretty much just that . what is your
revenue
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WHYRATIOS HELP YOU COMPAREbut it does not tell you if that is…‘good’
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WHYRATIOS HELP YOU COMPAREthat’s where ratios come in
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WHYRATIOS HELP YOU COMPAREbut let’s look at a concrete example
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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
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WHYRATIOS HELP YOU COMPAREyou happy with that as a founder? do
you understand your business?
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WHYRATIOS HELP YOU COMPAREnot really
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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
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WHYRATIOS HELP YOU COMPAREbut, can you see the problem?
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WHYRATIOS HELP YOU COMPAREthis business is making money now,
but it cannot scale
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WHYRATIOS HELP YOU COMPAREyou can see this clear as day if you
consider the most basic Ratio:
Profit Margin
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WHYRATIOS HELP YOU COMPAREprofit margin is calculated as:
net profit / sales
it tells you how much money you make for every $1 in sales
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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
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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
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WHYRATIOS HELP YOU COMPAREwhy?!?
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WHYRATIOS HELP YOU COMPAREwhy is your margin shrinking?
is it revenue?
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WHYRATIOS HELP YOU COMPAREwe can check out the Sales Growth
Ratio which is calculated as:
(current period sales – previous period sales) / previous period sales
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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
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WHYRATIOS HELP YOU COMPAREso if it is not revenue that is pulling
down your profitability, it must be cost
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WHYRATIOS HELP YOU COMPARElet’s look at the Operating Expense
Ratio which is calculated as:
operating expenses / revenue
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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
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WHYRATIOS HELP YOU COMPAREdo we need to fire the plant manager?
are we somehow exposed to some raw materials cost fluctuations?
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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)
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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
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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
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WHYRATIOS HELP YOU COMPAREbut they’re useful for one other thing as
well
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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
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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%
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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
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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
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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
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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
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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
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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
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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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