Liquidity ratio, current ratio, Berry ratio. Before you dig into each one of them, what ratios do you really need and how to use them
July 8, 2020
Startup financial ratios also referred to as financial metrics, should be different from the corporate financial ratio, just like the startup marketing plan is different from the corporate financial ratio. That said, financial ratios are an essential managerial tool. The first-time CEO should make himself acquainted with the main ones and drive the discussion around what to monitor and why. Choosing the proper startup financial ratios will help you focus your company and help to solidify your perception as a capable CEO.
What are financial ratios?
A financial ratio is a number that provides info about a specific aspect of your business. The motivation for using financial ratios is to simplify and standardize the discussion around it.
To give an analogy, think about the Body Mass Index (BMI) for people.
Different people have different heights and weights. BMI combines the two numbers into a metric that helps to identify weight problems. Given a specific BMI number, no one can tell the complete picture of a person's health. Still, it allows comparison to a safe benchmark and compares people and compares between different periods for the same person.
The key takeaways are:
Financial ratios are numbers representing a business aspect - for example, net cash flow
A single financial ratio can't provide the complete picture of your business
How should you be using financial ratios?
The steps to using financial ratios are:
Identify the business aspect you care to monitor
Identify all financial ratios that provide info on that aspect and choose the most fitting. I strongly recommend always choose the more straightforward alternative.
Understand the components of the financial ratio, what makes it, how it is calculated, and what affects its values.
Identify the stakeholders that care about this financial ratio and what is the frequency and cadence that updates need to be served to them
Plan how to drive data to allow an up-to-date calculation of the metric
Serve the metric to the stakeholders with insights
Who should be monitoring financial ratios in a startup?
Since the financial ratios are a managerial tool, they should be used by all the managers who share the responsibility of a specific aspect. Moreover, it's best if each of the stakeholders will clearly define what metrics they care about, why they care for it, and the frequency they need to update that metric.
I recommend identifying the "why" for each metric. People tend to request a shopping list of all metrics they used in their corporate job without solid motivation and understanding of the value of those metrics. More metrics mean more effort to collect and maintain the up-to-date, communicate them efficiently, and have a constructive discussion of its plan o the company.
Some financial ratios such as "Days in accounts receivables" may be shared with a broad audience in the company as a KPI, while others will be more strictly controlled due to sensitivity.
The immediate stakeholders are the CEO, Board of directors, company CFO (internal or external), auditor, and department managers.
It's best to communicate with the stakeholders and reach an agreement on what you report and why. Don't wait for an anxious board member to demand a "surprise" metric. Always communicate and set expectations.
What is the difference between KPI’s and financial ratios?
Key Performance Indicators (KPIs) can be anything the company chooses to indicate the progress and successful execution of its business. That indication may or may not be related to anything financial. For example, a B2C company may identify ADU (active daily users) as its most important KPI. This number may later translate into dollars based on conversion rates etc., but by itself, it is not related to anything financial.
Moreover, many companies chose KPI's that are very specific to their industry or echo-system that might be very foreign in other businesses. For example, many energy companies look at emission volume as a KPI. Naturally, this number will not be relatable to any B2C tech startup.
Unlike KPIs, financial ratios focus on describing primarily the business's financial aspects or ones that directly correlate to the company's records. Looking back at our previous B2C example, growth in DAU will not indicate the company's books, but a change in cash flow will be directly reported in the company's books. In many cases, they will be related to income statements reporting laws, financial audits, and Generally Accepted Accounting Principles (GAAP).
Specific financial ratios values vary significantly between industries but tend to have lower variance between companies in the same industry. As that is the case, financial ratios are often used as an indicator or a benchmark for the company's performance. For example, the gross margin ratio describes the ratio between product price (how much the customer paid) and product cost (how much the company paid to produce it). The GM ratio of a specific company is expected to be close to the average GM across that company's industry. If the company's GM is lower, it will need to explain why that is the case.
KPIs can be related to any aspect of the business
KPI's can be very "local" to industry and even "private" just for a specific company
Financial ratios calculations are uniform across all industries
Financial ratios values vary significantly between industries
Financial ratios are used as a benchmark within the industry
Essential and Incidental startup metrics
Some people are completionists. Those should keep away from financial ratios lists as there are so many of them it is impossible to maintain them even for a corporate. For example, here is a list of 101 financial ratios, and here is a breakdown by subject. Mostly, monitoring too many financial ratios is probably not efficient, and thus - these are the ones you must focus on.
The top 3 ratios all startups must monitor are:
Days until you’re dead - structured as a burn chart. This ratio is crucial to understanding how fragile the company is and if and when to fundraise or make an aggressive shift in plans. To calculate this, you'll need to keep an eye on the current cash balance and net cash burn
LTV to CAC ratio
The strong motivation is to identify as early as possible if the unit of economics will ever make sense. You might be playing in a field where the cost of customer acquisition is so high; the business doesn't make sense.
Many young companies avoid monitoring this ratio because they feel they don't have enough data. Usually, you have enough data, but it just looks so sad you'd rather ignore it. Don't. Don't ignore it, and don't get gloomy by it. Just be aware it needs to be improved for your company to succeed and continuously improve it.
And this is true for both SaaS companies as well as other business models.
Revenue growth We assume that you want to build a big company. While there are many ways to measure the size of a company, revenue is the simplest one.
Case study - growth vs cash
Let's assume it' Jan-2022, and an early-stage b2b ed-tech (education technology) startup is seeing great success in its latest offering to schools. The CEO considers the right timing for fundraising and how much to spend on marketing for growth.
The company's customers are characterized by a rigorous and reliable payment discipline and enjoy very favorable payment terms of up to 90 days between booking and payment. In this situation, if the marketing spends on marketing, it might grow in the booking. Still, cash delays may risk bankruptcy - simply as it won't have the liquidity (i.e., money in the bank) to pay its employees and suppliers.
Liquidity is monitored by everything related to cash, and probably most fitting for this case is Net cash flow and cash at each period.
Net cash flow is a metric calculated for a specific period, usually a month, a quarter, or a year. It aggregates all the cash that flowed "into" the company in that period and subtracts all the cash that flowed "out" of the company. Positive net cash flow is a good thing.
Here is the data:
Staring period: 2020-Jan
Cash balance beginning of starting period: $600K
"Normal business" cash expenditure: $300K/Month
Monthly cash received from customers at the starting period: $200K/Month
Assumptions: Any increase of $X in monthly marketing spend will lead to $2X in bookings (this is the dream of any business). The cash collection is 80 days from booking.
Here are two alternatives.
Alternative A - conservative:
The company is keeping things steady.
It's not showing growth which will make fundraising harder, but it has six months (until June-2022) to raise a follow-on round.
Alternative B - aggressive:
The company is sacrificing stability for growth to be more attractive to fundraising.
But wait. Looking at "Net cash" produced by the company and its balance at the beginning/end of every period, it's clear the company won't last beyond March-2020. As that is the case, unless the company can raise within three months, this aggressive strategy will be a losing one.
Focus and ignore the noise
Many entrepreneurs have different opinions on what is important to monitor. Some is based on past experiences, and some on passed on knowledge they picked along the way. It would help if you always listened to suggestions, but be careful of overthinking it in the early stages. A company that doesn’t monitor any ratio and has happy customers is a much better position with full blown data analytics system and no customers, so keep your eyes on the prise and use the ratios as supportive tool.
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