Understanding Basic Financial Ratios
Background
When investors are looking at a company’s pitch, they will have to cut through the messaging to determine how effectively the business operates. Beyond the topline growth and user conversion, we need to understand the investment’s financial health and reliable accounting to determine what can generate a return. Investors in VC & PE have many financial tools at their disposal, and one of these is financial ratio calculations. These will primarily appear in growth-stage companies, where later-stage VC and PE firms have more financial information to use. We will walk through some top metrics for investors and founders to use when evaluating an opportunity.
As an investor, you will need the company’s accounting documents (balance sheet, income state, etc.) to determine these metrics.
Gross Profit Margin Ratio
This metric is a quick measure of the company’s financial health by showing revenue after deducting COGS (Cost of Goods Sold).
Calculation: (Revenue-COGS) / Revenue
Net Profit Margin Ratio
Unlike gross profit, this metric determines the overall profitability of a business.
Calculation: Net Income / Revenue
Working Capital Ratio
In general, this calculation helps us determine if a company has enough assets to cover its debt.
Calculation: Current Assets / Current Liabilities
Operating Margin Ratio
This metric tells us the return on sales and the profit a company makes after paying for variable costs but before deducting taxes or interest.
Calculation: Operating Earnings / Revenue
Debt to Equity Ratio
This ratio helps us conclude a company’s financial leverage. There are industry nuances for a “good” number, but anything over 1.5 is typically unacceptable.
Calculation: Total Liabilities / Total Assets
Accounts Receivable Turnover Ratio
This accounting measurement shows how well a business executes its ability to collect payments, pay off debt, and how well it uses its assets.
Calculation: Sales / Accounts Receivable
Return on Equity Ratio
This metric shows how profitable a firm is to the money invested by shareholders. It answers how well the company is doing with the capital invested.
Calculation: Net Income / Shareholder’s Equity
Return on Investment Ratio
This performance metric tells us the efficiency of our investment. We can use this number to compare to other investments we have made.
Calculation: (Investment Gain - Total Investment) / Total Investment
Final Thoughts
These quick ratios will help any investor determine how well a company is managing its accounting. They are quick to calculate, but we need critical information from businesses to gather the information necessary to calculate them. Many early-stage companies operate at a loss, but as companies evolve further and grow, these need to reflect a positive trend in the business.