18 Financial Ratios Every Founder Should Know
Be prepared for your next pitch with this essential financial knowledge!
Knowledge is power, as the old adage goes. Any founder worth their salt shouldn’t only be aware of these financial ratios, but be prepared to know how to use them.
It’s not about being a SaaS startup, Tech startup, or an Ecommerce startup, it’s about the entrepreneurial drive. The key thing about successful founders is that they’re willing to brush up on their knowledge and use that to grow their business.
Why you need to know accounting ratios
Successful founders will use excellent accountancy services. With top tier accountants and CFOs, you can build a business with a secure financial base, and scale up in safety.
So why should you bother learning financial ratio formulas?
Because although smart founders can, and do delegate financial responsibilities to professionals, it’s out of choice rather than necessity. Successful business owners don’t hand over financial responsibilities out of ignorance, they hand them over to those best suited for the job so that they can get on with the real work of running their business.
Not only that, but once your financial experts provide their regular reports, analyses and checks you’ll be in a situation where you can understand. You can better comprehend the strategies that your CFO suggests because you can keep up with the acronyms and financial formulae that they use.
Knowing your financial ratio definitions also helps you nail a winning pitch. You may have clean financial health and a solid financial model, but you’ll also be ready for the trick questions potential investors have ready for you.
So without further ado, let’s crack on with the 18 financial ratios every founder should know about!
Business metrics & financial ratios
1. Burn rate
From the moment your Startup launches, you are on a timer known as burn rate.
Essentially your burn rate is the rate at which your startup burns through its initial capital. Before your startup begins to garner revenue/subscribers/customers, you will always be on this countdown as your original capital is used. Your expenses can be on staff, premises, utilities, digital tools and anything else.
The financial ratio formula for burn rate is:
Burn rate = (starting balance - ending balance) / number of months
Using this formula you can determine the rate at which you are burning through your original capital.
Knowing your burn rate is essential for your…
2. Cash runway
The second of the most important accounting ratios for startups, is the cash runway. It goes hand in hand with burn rate because you need your burn rate to determine cash runway.
Essentially, your cash runway is how long you have left before you go bust!
Just as burn rate is the rate at which you spend your initial capital, cash runway is how long you can sustain that level of spending before it’s all gone. The financial formula is:
Cash runway = current cash balance / burn rate
It defines the number of months left that your business can sustain your level of spending. As you decrease your burn rate, either by cutting costs or increasing your revenue, you will see your cash runway increase.
But don’t let these figures dissuade you. Many startups such as Uber, Tesla & Spotify weren’t profitable during their humble beginnings. Now, you’d be hard pressed to find someone in the world who hasn’t heard of these names!
3. Cost of goods sold (COGS)
Learning how to calculate the cost of goods sold is not only an essential metric for defining your real business revenue, but it can also be used to find a whole host of various business performance metrics too.
Now your COGS metric will only be used for businesses that sell products. If you don’t, then you’ll probably need to look more at operating expenses.
However, your COGS metric is essential in calculating your gross profit margin, making smart pricing decisions and much more. The financial ratio for COGS is:
(Starting inventory + purchases) - ending inventory = COGS
This is a way of examining the costs associated with acquiring, manufacturing and assembling your product within a strict time definition.
If your total revenue for the year is not larger than your COGS, then you haven’t made any profit, let alone enough to cover the rest of your operating expenses!
4. Average revenue per user (ARPU)
Attention all SaaS Startups, this one’s for you!
Well, not really. But you’re more likely to need this formula if you’re a SaaS startup due to its relevance to subscription service models. Your average revenue per user can indicate a skewing of your pricing levels.
For example, if you have 3 pricing levels of £5, £25 and £50 a month, but your ARPU lies somewhere around the £10 mark - your ARPU is dreadfully low.
Such a result can indicate that the pricing levels of your more profitable services do not match customers’ needs, or are incongruent with the service that you provide. The ARPU formula is:
Total revenue from users over a certain period / Number of users during the same period
This financial ratio formula will also be essential in calculating your…
5. Monthly recurring revenue (MRR)
The good news is that if you are a business that doesn’t provide a subscription service, then you won't have an MRR. But they are a good financial metric to understand, especially since subscription services are on the rise and offer value to both consumers and businesses. So learn with us just in case you’re looking to add to your financial model!
Monthly recurring revenue, or MRR, is primarily associated with SaaS Startups.
With subscription models, you always have new customers signing up and old customers leaving your services creating customer churn. Your MRR is a financial ratio that defines the fluctuations as growing or shrinking, and by what percentage.
It can often be used as an early warning sign that something is wrong with your subscription services - especially if you have rolled out a price change or altered your service coverage. Alternatively, it’s also a useful gauge for the future, as you can use the financial forecasting probabilities to estimate your revenue and growth over the next 3, 6, 9 or 12 months. The formula for standard MRR is:
MRR = Number of subscribers x ARPU
However, you can expand on this formula in a number of different ways to determine your additional revenue from existing customers upgrading their price plans (Upgrade MRR), from winning back lost customers (Regain MRR), or your lost customers (Churn MRR).
The variations can be used by accountancy and finance experts in as many different ways as you need to identify weak points within your business and push on your more profitable ones.
Snag venture capital investors for your startup!
6.Revenue churn + customer churn
This time you’re getting two financial ratio definitions for the price of one!
Essentially your churn rate is how much you are losing in a subscription business. With revenue churn, it’s about lost revenue. With customer churn, it’s about lost customers.
Both of these metrics are calculated in almost exactly the same way, and both offer valuable insights into your business. If your customer churn is high, but your revenue churn is low, then it could be that your higher pricing models are paying off in the form of high customer retention. You may need to revisit your lower-priced tiers to try and recapture some of your lost customers. Either way, the lower your churn rate, the less you are losing.
Revenue churn = (MRR beginning of the month - MRR end of the month) - Upgrade MRR during the month / MRR beginning of the month
This percentage gives you your churn rate. With a negative churn rate, you have actually gained revenue.
Customer churn = (Customers beginning of the month - Customers end of the month) / Customers beginning of the month
In exactly the same way, the bigger the churn, the more customers you have lost. If your customer churn is negative, then you have gained customers!
7. Operating profit
Operating profit is also known as EBIT and is absolutely not to be confused with EBITDA. That’s a whole other kettle of fish.
Your operating profit is an indicator of your company’s profitability, and it shows your business revenue minus expenses excluding taxes and interest. It’s also known as EBIT or operating income.
The financial ratio definition for Operating Profit is:
Operating profit = revenue - COGS - operating expenses
8. Gross margin & operating margin
These two accounting ratios are absolutely essential, especially when it comes to assessing your company’s profitability.
Your gross margin is:
Gross margin = gross profit / sales
With this in mind, your gross margin tells you how much of the revenues are kept as profits rather than expenses. For example, if your gross profit is £83,000 and your sales are £100,000, then your gross margin is 83%.
Your operating margin works under a similar principle:
Operating margin = operating profit / sales
9. Customer lifetime value (CLV)
Your customer lifetime value tells you how much worth a customer provides to your business over their period as a customer.
It’s a vital financial ratio to understand, as in business it is far easier to retain customers than to acquire new ones (see customer acquisition cost below). If you can maximise your CLV, you’ll have to worry less about drawing in new customers and balancing your CAC against the new revenue.
By enhancing your relationship with customers and promoting brand loyalty, you can ensure financial security for your business. The formula for CLV is:
CLV = average transaction x number of transactions x retention period
When considering your CLV, you also have to consider your CAC, otherwise known as your…
10. Customer acquisition costs
As a startup, you’ll face difficult decisions when it comes to marketing. And this is one of the most important KPIs for startups when it comes to measuring growth. Whether it’s through organic SEO, PPC advertising, affiliate marketing and many more.
The financial formula for CAC is:
CAC = Cost of sales & marketing / number of new customers
This financial ratio goes hand in hand with your CLV. The higher your CAC, the more your CLV has to pay off to provide an overall profit.
If your CLV is somehow less than your CAC, then every new customer is another drain on your profits. You’ll need to take a new look at the services you offer customers, or else redirect your marketing efforts.
11. CAC Payback
Your CAC payback is as we hinted at previously: the time taken to pay back the acquisition costs of a customer. As time goes on and you retain your existing customers, it takes a certain amount of time to make an overall profit.
The financial ratio formula for CAC Payback is:
CAC payback = CAC / MRR
12. Average collection period
When it comes to accounting, knowing when you get paid is everything. It can make a huge amount of difference to trained accounting professionals.
Your average collection period will help your CFO with their financial forecasting by indicating your levels of revenue in the immediate future. It’s no use knowing that customers owe you money if you don’t know when you can make use of it!
Average collection period = days in the period x average accounts receiveable / amount of net credit sales in that period
13. Average days payable
In a direct reflection of the average collection period, your average days payable tells you how long you are taking to pay suppliers.
Sometimes, these two financial metrics work in tandem, allowing you to estimate when revenue is coming in, so that you can then use it to pay your suppliers. Although hopefully, you have the capital spare so that it isn’t a problem!
Average days payable = days in the period x average accounts payable / total amount of purchases on credit
14. Inventory turnover
Inventory turnover is a measure of how quickly it takes for you to sell items in your inventory. Inventory that sits on your shelves or in your warehouses isn’t making you money. Unless it is a super rare comic book that is gaining rarity or a quality wine that’s simply becoming finer, it’s actually costing you money.
Inventory turnover’s usually much higher with common items, and lower with designer luxury items. But, your current inventory turnover’s especially useful in comparison with previous inventory turnover.
High inventory turnover can point to excellent business. Butit can also be a sign that you should increase your inventory of that product. Low turnover points to low market demand for certain items - so you’ll need to think on your feet to sell them.
To calculate your inventory turnover you’ll need the financial formula for average inventory which is:
Average inventory = (beginning inventory + ending inventory) / 2
After that, the financial ratio formula for inventory turnover will be:
Inventory turnover ratio = COGS / average inventory
We can take this one step further and work out how long it will take to sell the inventory that we have on hand.
Let’s say that for the year, our COGS is £45,000 and our average inventory is £15,000. Our Inventory turnover ratio is 3. If we divide 365 by 3, we can see that the average number of days it will take to deplete our inventory will be 121.67 days as long as it isn’t a leap year!
Advanced accounting ratios for businesses
So far, we’ve covered the absolute essential financial ratios that every business owner should know, but now let’s get a little more complex.
15. The quick ratio
How fast can your company pay off short term debts? The quick ratio is a measure of liquidity and can signal to potential investors whether your business is in danger of running out of cash.
The quick ratio formula is:
Quick ratio = cash + accounts receivable - inventory / current liabilities
16. Debt to equity ratio
The debt to equity ratio (D/E Ration) gives accountants a quick snapshot into the capital structure of a company. Accountants can tell how leveraged a company is by its debts, rather than its own internal funds.
Accountancy experts calculate this by:
D/E ratio = debt / equity
A high D/E ratio shows that your business is failing to finance its own operations with its own capital and instead relies on borrowing.
17. Interest coverage ratio
As your business has debts, those debts will only increase via interest. The interest coverage accounting ratio informs you of your business’s ability to generate adequate income to cover the interest on your debts.
It’s also known as times interest earned ratio and it is calculated like this:
Interest coverage ratio = EBIT / interest expense
Ideally, having an interest coverage ratio of 2 or higher is sufficient, but more is always preferable to less.
18. Return on total assets (ROTA)
Your ROTA is a measure of your EBIT relative to your business’s total net assets. Or in short, how good your assets are at generating earnings
The greater your earnings compared to your assets, the more efficiently you run your business, and therefore the higher your ROTA will be. Or, if you look at it the other way, you can compare your competition’s ROTA with your own to see if you are matching their own efficiency.
The accounting ratio for ROTA is:
ROTA = EBIT / average total assets
If your coefficient is lower than the competition, it could be time for your CFO to take a look at where you can improve your financial efficiency.
Accounting and financial ratios made simple
The world of accountancy can be terribly confusing, especially for startups. You have so much more to focus on than simply a world of numbers. This was especially true for fresh Startup Pluto.
They could build their user base and revenue without a problem, but financial reporting was an issue… until they turned to us for help!
“Accounting and finance was just not something either myself or my co-founder had a huge amount of experience (or interest!) in...after the first 6 months, things started to get messy on our Xero account with our receipts...we quickly realised we needed someone who understood startups and also finance.”
We not only provided intelligent AI supported bookkeeping software, but our accountancy team handled their finances and brought them up to speed on accountancy lingo. From that moment on, they knew their finances were under control and how they were under control.
They understood the problems we were facing and their ongoing help was very cost effective. So it ended up being an easy decision!”
Since then, we’ve helped Pluto grow and expand both its user base, revenue and accountancy knowledge.
The accountancy experts
As accountancy experts specialising in startups, we understand the needs of young businesses. That’s why our entire setup is based towards growth and scalable support for your business.
Our digital accountants provide an experienced team at your fingertips, our CFOs create affordable bespoke financial models that land investors and our R&D Tax Credit Services have saved over £30 million in tax credits for startups.
Talk to one of our accountancy specialists today and learn more about the savings and growth that your company could make use of. Also, make sure to sign up for our free School of Startups. The online database of guides, videos and webinars made by CEOs and entrepreneurs to advise the next generation of business owners!