Adam Poole, CPA
MAXIS® by Freed Maxick assures organizational effectiveness for startups
In the prior two ‘financial statements for startups’ articles, we address four common challenges that startups must conquer and the strategies to help overcome them. This third and final article takes aim at the three key ratios that startups should be very familiar with and use.
Taking your startup to the next level means understanding how to interpret and wield financial statements to determine the performance of your business, as well as what potential decisions need to be made. An important consideration is that all ratios should be compared against industry standards in order to compare “apples to apples.” For example, an industry with high inventory, such as retail, is probably not best compared against a tech startup that will have higher fixed asset costs and minimal inventory.
Benchmarking Financial Ratios for Startups
The Bureau of Labor Statistics reports that 20% of new ventures fail in the first year, 30% fail in the second year and by year 5 about 50% of them have shuttered. Being acutely aware of certain quantitative benchmarks may help to determine whether a startup is able to not only survive, but thrive. There are three key ratios that every startup should calculate to analyze important factors:1.) Working Capital: This is calculated as working capital equals current assets minus current liabilities.
This basic equation tells you one important thing: Does your business have enough assets to cover your liabilities? This is useful for measuring operational efficiency and short-term financial health. Positive working capital (i.e., assets are greater than liabilities) demonstrates that a company holds enough liquid assets to meet short-term liabilities. Investors utilize this formula as a preview of a company’s ability to maneuver difficult financial periods. The amount of working capital can vary depending on stage life, industry, geography, the type of business, and more.2.) Gross Profit Margin Ratio: This is calculated as gross profit margin ratio equals (revenue minus cost of goods sold (COGS)) divided by revenue.
The gross profit margin ratio is an indicator of a company’s financial health; it tells investors how much gross profit is earned on each dollar of revenue. Compared with a relevant industry average, a lower margin could indicate a company pricing its products too low and not maximizing the market’s willingness to pay higher prices. A higher gross profit margin may indicate that a company can make a reasonable profit on sales, as long as it is maintaining controlled overhead expenses. Generally, investors will be more interested in a company with a higher gross profit margin.3.) Return on Investment (ROI): This is calculated as ROI equals (gain from investment minus the cost of investment) divided by the cost of investment.
This is one of the most important metrics to an investor, if not the number-one metric. Investors, lenders and shareholders want to make sure they are receiving a return on their investment in your company; if they are not making/expecting to make a profit, they will look elsewhere—fast. This is an extremely useful pro forma tool to determine the expected profitability of certain efforts or campaigns; if your company will make more money generating interest in a bank account than the calculated ROI on a particular decision, the money should stay put until factors change and the return on investment becomes material. Additionally, ROI can be calculated post-op to answer the question, “What did I get for my money?” This can be an effective conversation starter for setting course on future decisions; continue investing as you are or determine an alternate, more lucrative avenue to focus your capital. Either way, calculating ROI on business decisions provides insight on whether specific efforts are an efficient use of capital and rudimentarily gauges profitability.
MAXIS brings expertise and insights that deliver the highest levels of strategic leadership, consistent results, and extraordinary business value.
To begin, dependable technology automates menial, repetitive, and transactional tasks. Customized dashboards monitor the data to provide tools and resources for leaders of startups to understand — at any point in time — how the business is performing. Being able to respond quickly with agile decisions to reduce loss and risk, and increase productivity and profitability. The ability to create a unique path to your company’s goals is more easily achievable with MAXIS.