First-Time-CEO

Early Stage Startup Financial Metrics

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

Laura Benson

July 8, 2020

Early Stage Startup Financial Metrics

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 a very important managerial tool and the first time CEO should make himself acquainted with the main ones, as well as drive the discussion around what to monitor and why. Choosing the right startup financial ratios will both help you focus your company as well as help to solidify the perception of you 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 height and weight BMI combines the two numbers into a metric that helps to identify weight problems. Given a specific BMI number, no one can tell the full picture of a person’s health, but it allows both to simply put things into ranges, as well as to compare between people, and compare between different time 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 full picture of your business

How should you be using financial ratios

The steps to using financial ratios are:

  1. Identify the business aspect you care to monitor
  2. Identify all financial ratios that provide info on that aspect and choose the most fitting. I strongly recommend to always choose the simpler alternative.
  3. Understand the components of the financial ratio, what makes it, how it is calculated, and thus what affects its values.
  4. Identify the stakeholders that care about this financial ratio and what is the frequency and cadence that updates need to be served to them
  5. Plan how to drive data to allow an up to date calculation of the metric
  6. Serve the metric to the stakeholders with insights

Who should be monitoring financial ratios in a startup

Since the financial ratios is 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 in advance what metrics they care, why do they care for it, and what is the frequency they need an update of that metric.

I recommend to clearly identify the “why” for each metric as people tend to request a shopping list of all metrics they used in their corporate job without strong motivation and understanding of the value of those metrics. More metrics mean more effort to collect and maintain the up to date, to communicate them efficiently, and have a constructive discussion on the plan o the company.

Some financial ratios such as “Days in accounts receivables” may be shared with a wide 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 of 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 as an indication of 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 it’s 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 kinds of 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 financial aspects of the business, or ones that have a direct correlation to the company’s records. Looking back at our previous B2C example, growth in DAU will have no indication in 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 greatly between industries but tend to have lower variance between companies in the same industry. As that is the case, many times financial ratios are used as an indicator or a benchmark to 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 industry that company operates in. If the company’s GM is lower, it will need to explain why that is the case.

Takeaways:

  • 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 greatly 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.

    Important to understand how fragile the company is and if and when to fundraise or make aggressive shift in plans.
    In order to calculate this you'll need to keep an eye on 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 in order for your company to succeed and always look to improve it.

    And this is true for both SaaS companies, as well as other business models.
  • Revenue growth

    Our assumption is that you want to build a big company. While there are many ways to measure the size of a company, sales number is the simplest one, especially for a technology company.

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 as well as how much to spend on marketing for growth.

The company’s’ customers are characterized by a very strict and reliable payment discipline, but also 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 booking, but cash delays bit get it to bankrupt - 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 that is 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 in that period. 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 6 months (until June-2022) to raise a follow-on round.

Conservative on cash burn
Alternative A - conservative but company may raise

Alternative B - aggressive:

The company is sacrificing stability for growth in order to be more attractive to fundraising.

But wait. Looking at “Net cash” produced by the company and it’s 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 3 months, this aggressive strategy will be a losing one.

Alternative B - aggressive but company will die
Alternative B - aggressive but company will die

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