Financial Ratios help companies assess their current financial health as well as compare their financial standing to past performance and industry standards. When applying these ratios to startups, entrepreneurs can measure the success of their venture, including profitability, liquidity and efficiency. Knowing these metrics can provide valuable insight into a new business’s progress and future potential.
Benefits of evaluating financial ratios include a better understanding of the company’s finances, alternative points of view, improved decision-making and proactively managing risks.
- Financial Ratios can help startups assess their financial standing and future potential.
- Measuring these metrics can provide entrepreneurs with valuable insight.
- Benefits include better understanding of finances, improved decision-making and proactively managing risks.
Common Financial Ratios for Startups
Startups that are launching or maturing need to assess their financial viability and performance accurately. Financial ratios are a key tool used by investors and analysts to measure the stability and growth of businesses. Common financial ratios used to evaluate the performance of a startup business include liquidity ratios, efficiency ratios, profitability ratios, and leverage ratios.
Liquidity ratios measure a business’s ability to convert assets into cash quickly and pay its current liabilities. Common liquidity ratios used to evaluate the financial performance of a startup include:
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Current Assets - Inventories) / Current Liabilities
- Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Efficiency ratios measure how quickly and effectively a business is using its resources to create products or services. Key efficiency ratios used to assess the performance of startups include:
- Days Sales Outstanding (DSO) = (Accounts Receivable) / (Sales / 365)
- Inventory Turnover Ratio = (Cost of Goods Sold) / (Average Inventory)
- Asset Turnover Ratio = (Revenues) / (Average Total Assets)
Profitability ratios measure the income and profit earned by the business relative to its expenses, assets, and liabilities. These ratios are useful for evaluating the performance of a new business. Common profitability ratios used to evaluate startups include:
- Gross Profit Margin = (Gross Profit) / (Total Revenues)
- Return on Assets (ROA) = (Net Income) / (Total Assets)
- Return on Equity (ROE) = (Net Income) / (Shareholders’ Equity)
Leverage ratios measure the degree to which a company is using debt or equity to finance its operations. These ratios are important for assessing the risk of a startup business. Popular leverage ratios used to evaluate startups include:
- Debt-to-Equity Ratio = (Total Debt) / (Stockholders' Equity)
- Interest Coverage Ratio = (Operating Income) / (Interest Expense)
- Fixed-Charge Coverage Ratio = (Earnings Before Interest, Taxation, Depreciation, and Amortization) / (Fixed Charges)
As startup owners evaluate their business and its performance, liquidity ratios are essential to measure the company's ability to pay off its debts and liabilities. These ratios look at a company’s cash availability, such as its current assets versus its current liabilities. Let’s explore two of the most common liquidity ratios.
The current ratio is the ratio of a company’s current assets to its current liabilities. This ratio helps startup owners understand their company’s ability to pay off short-term obligations. A higher current ratio indicates that a company is in a good financial position and is able to meet its short-term liabilities.
The quick ratio, also known as the acid-test ratio, is a more advanced version of the current ratio that excludes the company’s inventory from the current asset calculation. This ratio only includes cash, cash equivalents, and other marketable securities that can quickly be converted into cash. As a result, this ratio is a better indicator of a startup’s financial health.
Efficiency ratios measure the ability of a business to convert its resources into cash or sales. They show how well a business is operating and how efficiently they are in managing their accounts. These ratios help investors and analysts to gauge the effectiveness of a company’s financial strategies and operations.
Inventory turnover is the ratio of total cost of goods sold to the average inventory. This ratio indicates how quickly a company can turn its stock into sales. A high ratio suggests that a company is able to move its inventory quickly, while a low ratio suggests that the company is not turning its stock quickly enough.
Accounts Receivable Turnover
Accounts Receivable Turnover is the ratio of net sales to average accounts receivable. This ratio measures how quickly customers are paying back their bills. A high ratio indicates that customers are paying promptly, while a low ratio suggests that customers are slow in settling their accounts.
Efficiency ratios are important indicators for investors and analysts to understand the effectiveness of a company’s strategies and operations. Analyzing these ratios can provide valuable insights into the performance of a company, especially startups.
Profitability ratios are used to evaluate a startup’s ability to generate profits relative to a range of other factors. These ratios measure the overall efficiency and ability of a business to generate more revenue than it is spending. Understanding the key profitability ratios can help startup owners understand their company’s performance and make informed decisions to improve financial performance.
Gross Profit Margin
The gross profit margin measures the total amount of revenue earned minus the cost of goods sold, compared to total revenue. It is the profitability ratio of the startup that indicates the margin of revenue available to cover other expenses and provide income for the business. Calculating the gross profit margin helps startups identify areas of financial inefficiency and pinpoint operational expenses that may need to be lowered in order to maximize profits.
Operating Profit Margin
The operating profit margin is a measure of the startup’s overall profitability. This measure factors in all operating costs, including costs of goods sold, operating expenses, and other costs associated with creating and selling products and services. The operating profit margin is an indicator of how efficiently a startup is managing its money and provides insight into areas where interventions may be necessary to improve financial performance.
Return on Assets
Return on assets (ROA) is a measure of financial performance that looks at how much revenue a startup is able to generate from the use of the company’s assets. ROA helps provide important insight into the efficiency of management in allocating resources in the most profitable way, and highlights areas where investments or changes in operations could improve performance.
- Gross Profit Margin
- Operating Profit Margin
- Return on Assets
Leverage ratios are used to measure the risk a company takes in financing its operations and assets with debt. Generally, leverage ratios measure the ability of a company to meet its long-term debt obligations. It is important in evaluating a startup's performance because high debt levels could pose a great risk to the company. The most common leverage ratios used in evaluating the performance of a startup are the total debt to equity ratio and the interest coverage ratio.
Total Debt to Equity Ratio
The total debt to equity ratio is used to measure a startup's ability to repay its debts. The ratio is calculated by dividing the total liabilities of a startup by its total equity. The total debt ratio is an indication of the level of financial leverage used by a startup and the degree of solvency of the company. A high total debt ratio may suggest that the startup is using more debt financing than equity financing, which may put its liquidity at risk.
Interest Coverage Ratio
The interest coverage ratio is used to measure a startup's ability to service its debts. The ratio is calculated by dividing the company's earnings before interest and taxes (EBIT) by its total annual interest expense. The higher the interest coverage ratio, the greater the ability of the startup to cover its interest payments. A low interest coverage ratio may indicate that the startup is struggling to pay its interest expenses and may put the company's liquidity at risk.
It is important for startups to monitor their leverage ratios as it can give them an indication of how well their business is performing. Leverage ratios can help startups identify potential problems before they become too severe and take the necessary actions to improve their financial position.
Using financial ratios to measure the performance of a startup can provide a significant amount of insight into its successes and challenges. Financial ratios provide a type of financial analysis that can help entrepreneurs track key performance indicators and assess investment opportunities. There are many financial ratios that can be used to evaluate a startup's performance, but the most common include gross profit margin, debt-to-equity ratio, and return on equity, among others. Additionally, debt coverage ratios, activity ratios, and liquidity ratios are also typically used.
By understanding the common ratios used to measure startup performance and how to interpret them, entrepreneurs can make better decisions that may contribute to the success of their startup. Ratios can be a useful tool to strengthen a startup's financial health and increase its chances of success.
Summary of Ratios
The most common financial ratios used to evaluate startup performance are:
- Gross Profit Margin
- Debt-to-Equity Ratio
- Return on Equity
- Debt Coverage Ratios
- Activity Ratios
- Liquidity Ratios
Recommended Resources for Learning More About Ratios
For entrepreneurs looking to better understand these financial ratios and use them to measure the performance of their startup, there are a number of helpful resources available. The following are just a few of the great resources available to learn about financial ratios:
- Investopedia's Guide to Financial Ratios
- The Balance Small Business Guide to Financial Ratios
- Entrepreneur's Guide to Financial Ratios
- Accounting Coach's Guide to Financial Ratios
- 5-Year Financial Projection
- 40+ Charts & Metrics
- DCF & Multiple Valuation
- Free Email Support