Understanding Basic Financial Ratios

Quick calculations to determine the accounting health of a business

Zeb HastingsNov 24, 2020Edit postPin on home pageExclude from Top

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.

This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.

Leave a Reply