Understanding Financial Ratios

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Understanding financial ratios Dirty little start-up Secret #14

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

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WHY RATIOS HELP YOU COMPARE you know, like…

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

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

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WHY RATIOS HELP YOU COMPARE you know, like… how much money do I have in the bank today? what are my operating expenses each month? h ow much cash can I expect to come in next week?

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WHY RATIOS 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

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WHY RATIOS HELP YOU COMPARE let’s look at revenue by month as an example w hat does that absolute number tell you?

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WHY RATIOS HELP YOU COMPARE p retty much just that . what is your revenue

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WHY RATIOS HELP YOU COMPARE b ut it does not tell you if that is…‘good’

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WHY RATIOS HELP YOU COMPARE t hat’s where ratios come in

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WHY RATIOS HELP YOU COMPARE b ut let’s look at a concrete example

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WHY RATIOS HELP YOU COMPARE h ere 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

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

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WHY RATIOS HELP YOU COMPARE n ot really

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WHY RATIOS HELP YOU COMPARE w hat if I add this bit of detail? wow! what an amazing business right? l ook 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

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WHY RATIOS HELP YOU COMPARE b ut, can you see the problem?

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

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WHY RATIOS HELP YOU COMPARE y ou can see this clear as day if you consider the most basic Ratio: Profit Margin

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WHY RATIOS HELP YOU COMPARE profit margin is calculated as: n et profit / sales i t tells you how much money you make for every $1 in sales

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WHY RATIOS HELP YOU COMPARE n ow look again o h 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

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WHY RATIOS HELP YOU COMPARE w here 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 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

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WHY RATIOS HELP YOU COMPARE w hy?!?

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WHY RATIOS HELP YOU COMPARE w hy is your margin shrinking? i s it revenue?

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WHY RATIOS HELP YOU COMPARE w e can check out the Sales Growth Ratio which is calculated as: ( c urrent period sales – previous period s ales) / previous period sales

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WHY RATIOS HELP YOU COMPARE h mmmm , 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

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WHY RATIOS HELP YOU COMPARE s o if it is not revenue that is pulling down your profitability, it must be cost

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WHY RATIOS HELP YOU COMPARE l et’s look at the Operating Expense Ratio which is calculated as: operating expenses / revenue

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WHY RATIOS HELP YOU COMPARE a-ha. something is stinky! y our 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

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WHY RATIOS HELP YOU COMPARE d o we need to fire the plant manager? a re we somehow exposed to some raw materials cost fluctuations?

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WHY RATIOS HELP YOU COMPARE l et’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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WHY RATIOS HELP YOU COMPARE u h…were 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

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WHY RATIOS HELP YOU COMPARE s o 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 i t allows you to identify & solve problems

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WHY RATIOS HELP YOU COMPARE b ut they’re useful for one other thing as well

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WHY RATIOS HELP YOU COMPARE b ecause 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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WHY RATIOS 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%

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WHY RATIOS HELP YOU COMPARE y ou can actually make ratios out of any combination of absolute numbers depending on what aspect of your business model you want to investigate h owever, certain classic ratios have shown great value, and your management team should be monitoring these monthly

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WHY RATIOS HELP YOU COMPARE p lease 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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l iquidity ratios tell you how much of your current assets can be used to meet short-term creditor claims APPENDIX Liquidity Ratios! Current Current Assets / Current Liabilities Quick (aka Acid Test) (Current Assets – Inventory – Prepaids ) / Current Liabilities

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h ow efficient is a firm at using its assets to generate revenue APPENDIX Activity 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

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w hat % of a firm’s assets are financed with creditor dollars (how much is owned by bank vs shareholders) APPENDIX Leverage Ratios! Debt to Equity Total Liabilities / (Total Assets – Total Liabilities) Debt to Total Asset Total Liabilities / Total Assets Times Interest Earned Operating income / Interest

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how well are we doing APPENDIX Profitability 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

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u sed to compare firms in a similar industry APPENDIX Market 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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