Over the beginning of this summer, I have had the chance to work with a few startups. While working with them, I realized there is a missing piece of core understanding that is needed to grasp financial ratios. These ratios tell a company, whether new and unstable or old and stable, a lot of important information that a business needs to know in order to make informed decisions. It is not enough to merely glance over the balance sheet if an owner wants to succeed, they need to understand what the numbers mean and what they can do to change their outcome. I will explain three ratios, solvency, efficiency, and profitability.
Starting with the solvency ratio, what is this? This is one of many ratios that is used to measure a company’s ability to meet long-term debt and obligations. In layman’s terms, the solvency ratio measures the size of the company’s after tax income, which excludes non-cash depreciation expenses, which is compared to a company’s total debt obligations. Essentially, this ratio provides a measurement of how likely a company will be able to pay its future debts and obligations. The equation to find this ratio is (after tax net profit + depreciation)/(long term liabilities + short term liabilities).
After giving the definition, let’s consider the importance of this ratio. Typically, a healthy solvency ratio is above 25%. The lower the solvency ratio, the more likely the company will default on its debts. When an owner is looking over their balance sheet, it does not take much effort to extract the required information to calculate this ratio, and it tells them so much. Yet, many owners miss these concepts, why is that? In many startups, the owner has thought of an idea, an idea they love. They are betting on their product doing well, which is perfectly fine. However, because they are so enthralled with their idea, they often believe they don’t need to worry about the fine details such as ratios to make decisions. Therefore, they bypass these issues and look at the big picture only. Knowing if you are able to pay your debts is imperative not only to you, but to your investors. In addition, knowing you have been able to consistently pay them reflects stability, showing a worthy company.
Secondly, we have efficiency ratios. Efficiency ratios are used to explain how well a company is using its assets and liabilities within the company. For example, how much liabilities and assets did the company have to take before reaching said goal. Although the calculations vary, the most common one is expenses/revenue. (Expenses typically do not include interest expense)
When an owner knows this ratio, they can quickly measure their ability to turn resources into revenue. The lower the ratio, the better. For example, if Walmart’s total costs, excluded interest expense, totaled $5,000,000,000 (B=billion), and their revenue totaled $8,000,000,000, (5B/8B=63%) they have a 63% ratio. This means that it took Walmart $.63 in expenses to generate $1 of revenue. That is not necessarily bad, nor is it outstanding. If a startup company owner can see this ratio on their normal expenses and revenues, they can understand how their company is doing and if they’re absorbing too much cost. If a company consistently checks this ratio on a monthly basis, they can see how they are trending and what types of expenses and revenues are causing the most fluctuations.
Lastly, we have the profitability ratios. These ratios, as the title suggests, helps explain what type of profits the company is achieving. More precisely, it assesses the company’s ability to generate earnings compared to its expenses. Some of the ratios include: profit margin, return on assets, and return on equity. We will specifically look at net profit margin (NPM). This ratio tells us how much profit a company sees for every dollar in revenue or sales. This ratio is the inverse of the efficiency ratio. The calculation is (net income/total income).
Looking at the calculation closer, let’s take the Walmart numbers. Net income = 8B-5B=3B, now we take the 3B and divide that by the total income of 8B, which equals 37%. In a neater form, (3B/8B=37%). Remember, our efficiency ratio was 67%, 1-.67=.37. Again, the NPM in the inverse of the efficiency ratio. So, Walmart has a NPM of 37%, this tells us that for every dollar they earn, they profit $.37. As the inverse of the efficiency ratio, we want the ratio to be higher, not lower. As a startup, the owner needs to know what types of profits they are seeing after expenses are deducted. Like all other financial analysis, this ratio needs to be done on a monthly basis to examine any trends or to simply have a specific idea of how well the company’s dollars are being used.