July 16, 2016

Apart from having a great product, good sales, good SEO, great marketing, and so on… there is one thing that is vital to the long term growth and success of a startup: good accounting.

And yes… you may not be as versed in numbers as your accountant is. But do understand: its essential to have a working knowledge of an income statement, balance sheet, and cash flow statement.

And along with that a working knowledge of key financial ratios.

And if these ratios are understood will make you a better entrepreneur, steward, company to buy and yes…investor.

Because YOU’LL know what to look for in an upcoming company.

So here are the key financial ratios every startup should:

1. Working Capital Ratio

This ratio indicates whether a company has enough assets to cover its debts.

The ratio is Current assets/Current liabilities.

(Note: current assets refer to those assets that can be turned into cash within a year, while current liabilities refers to those debts that are due within a year)

Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets; A ratio between 1.2 and 2.0 is sufficient.

So Papa Pizza, LLC has current assets are $4,615 and current liabilities are $3,003. It’s current ratio would be 1.54:

($4,615/$3,003) = 1.54

2. Debt to Equity Ratio

This is a measure of a company’s total financial leverage. It’s calculated by Total Liabilities/Total Assets.

(It can be applied to personal financial statements as well as corporate ones)

David’s Glasses, LP has total liabilities of $100,00 and equity is $20,000 the debt to equity ratio would be 5:

($100,000/$20,000)= 5

It depends on the industry, but a ratio of 0 to 1.5 would be considered good while anything over that…not so good!

Right now David has $5 of debt for every $1 of equity…he needs to clean up his balance sheet fast!

3. Gross Profit Margin Ratio

This shows a firms financial health to show revenue after Cost of Good Sold (COGS) are deducted.

It’s calculated as:

Revenue–COGS/Revenue=Gross Profit Margin

Let’s use a bigger company as an example this time:

DEF, LLC earned $20 million in revenue while incurring $10 million in COGS related expenses, so the gross profit margin would be %50:

$20 million-$10 million/ $20 million=.5 or %50

This means for every $1 earned it has 50 cents in gross profit…not to shabby!

4. Net Profit Margin Ratio

This shows how much the company made in OVERALL profit for every $1 it generates in sales.

It’s calculated as:

Net Income/Revenue=Net Profit

So Mikey’s Bakery earned $97,500 in net profit on $500,000 revenue so the net profit margin is %19.5:

$97,500 net profit $500,000 revenue = 0.195 or %19.5 net profit margin

For the record: I did exclude Operating Margin as a key financial ratio. It is a great ratio as it is used to measure a company’s pricing strategy and operating efficiency. But just I excluded it doesn’t mean you …