UNDERSTANDING FINANCIAL RATIOS DIRTY LITTLE START-UP SECRET #14

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

WHYRATIOS HELP YOU COMPARE you know, like

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

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

WHYRATIOS 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?

WHYRATIOS 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

WHYRATIOS HELP YOU COMPARE lets look at revenue by month as an example what does that absolute number tell you?

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

WHYRATIOS HELP YOU COMPARE but it does not tell you if that isgood

WHYRATIOS HELP YOU COMPARE thats where ratios come in

WHYRATIOS HELP YOU COMPARE but lets look at a concrete example

WHYRATIOS HELP YOU COMPARE here is a hypothetical business that makes concrete for buildings ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 200,000 250,000 330,000 600,000 1,100,000

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

WHYRATIOS HELP YOU COMPARE not really

WHYRATIOS HELP YOU COMPARE what 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 Q5 Revenue 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 COMPARE but, can you see the problem?

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

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

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

WHYRATIOS HELP YOU COMPARE now look again oh dear. margin is shrinking quickly! ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 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 COMPARE where you were making 70 cents per dollar of revenue in Q1, by Q5 youre only making .37 cents so youre selling more, but making less! ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 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 COMPARE why?!?

WHYRATIOS HELP YOU COMPARE why is your margin shrinking? is it revenue?

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

WHYRATIOS HELP YOU COMPARE hmmmm, despite a margin crisis, sales growth is actually improving over time kudos to your sales team ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 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 COMPARE so if it is not revenue that is pulling down your profitability, it must be cost

WHYRATIOS HELP YOU COMPARE lets look at the Operating Expense Ratio which is calculated as: operating expenses / revenue

WHYRATIOS HELP YOU COMPARE a-ha. something is stinky! your costs are growing out of control ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 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 COMPARE do we need to fire the plant manager? are we somehow exposed to some raw materials cost fluctuations?

WHYRATIOS HELP YOU COMPARE lets break our cost down into 3 categories (supply, manufacturing, distribution) & compare each against total cost (i.e.: supply cost / total cost)

WHYRATIOS HELP YOU COMPARE uhwere we too quick to congratulate sales? ConcreteMaster Inc. Q1 Q2 Q3 Q4 Q5 Revenue 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 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

WHYRATIOS HELP YOU COMPARE but theyre useful for one other thing as well

WHYRATIOS 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

WHYRATIOS 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? Quarterly Revenue Profit Margin ConcreteMaster 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 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

WHYRATIOS 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 ive 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 Liabilities Quick (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 Assets Total Asset Turnover Net Sales / Total Assets

what % of a firms 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 Assets Times Interest Earned Operating income / Interest

how well are we doing APPENDIXPROFITABILITY RATIOS! Gross Profit Margin Gross Profit / Net Sales Operating Profit Operating Income / Net Sales Net Profit Margin Net Profit / Net Sales Operating Return on Assets Operating income / Total Assets Net Return on Assets Net Profit / Total Assets Return 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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