Lenders, and often investors, will calculate one or more financial ratios when reviewing an entrepreneur's financial statements to gain a quick understanding of the health of the business before determining whether to lend or invest. Within an industry, there will be “good” and “bad” benchmarks against which the venture will be measured (Rogers, 2014). Investors and lenders will consider the particulars of a business and likely weight the importance of the ratios differently when comparing to the industry benchmarks.
Many financial ratios could be applied, but the following appears to be most common types (BDC Staff, n.d.):
Leverage Ratios. Leverage Ratios provide an indication of the long-term solvency and highlight the extent long-term debt is used to support the venture.
Liquidity Ratios. Liquidity Ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health.
Efficiency Ratios. Efficiency Ratios provide insights into operations and help to spot problem areas related to inventory management, cash flow, and collections.
Profitability Ratios. Profitability Ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry.
There are other ratios, of course, and as mentioned before investors particularly have ratios they rely on more based on their experience and industry knowledge. For example, a recent interview with an investor uncovered a preference for knowing the Customer Acquisition Costs. Customer Acquisition Costs are not often viewed as part of a Financial Ratio Analysis, but such factors are often important measures for both investors and entrepreneurs alike.
The entrepreneur, investor, and lender can gain useful information and financial trends on a business venture when using Financial Ratio Analysis. However, it is important to note that financial ratios have little meaning without comparison (Peavler, 2017). For example, a company can compare its ratios to those average ratios of their industries, but the best and most accurate comparisons come from using benchmark companies—high performing companies within their industry. Comparisons against these companies can create and encourage stretch goals for a business.
While Financial Ratio Analysis does provide numbers for performance comparison, it does not provide causation factors (Peavler, 2017). Moreover, identifying why certain ratios that are out of line with the benchmark comparisons is critical because it provides a starting point for correcting problems and improving financial performance. Ratio analysis can have value for entrepreneurs but depending on where the venture when it is seeking funds, these ratios may or may not be helpful in securing financing.
Entrepreneurs seeking early-stage financing are more likely to encounter investors who value continual improvements in customer acquisition costs, improvements in customer engagement at the various points of contact, and repeat purchase or purchase frequency. These measures help the investor gauge the interest in the offered products and services and are often a good predictor of long-term revenue.
Conversely, established entrepreneurial ventures—those that have several years financial history—looking for ongoing financing are likely to find as much emphasis placed on financial ratios as is placed on the customer measures noted above. This particularly true with bank financing because bankers are more risk adverse and financial ratios when properly utilized, provide a more objective measure of a venture’s performance compared to its industry thereby giving bankers a greater level of comfort when lending money.
Entrepreneurs are often motivated to launch a business in part because of their interest and expertise in a specific domain area. However, many entrepreneurs may be less skilled when it comes to the business finances beyond the basics of revenue and expenses. As an entrepreneur’s business grows, understanding key aspects of finance becomes increasingly more important, particularly should he or she seek outside investment or financing. It is important to understand the basics of Financial Ratio Analysis and how it can be used to determine the health of a business before seeking investment or financing. Yet it is equally important to understand that Financial Ratio Analysis is only one tool in an investor or lender’s tool-box. And while it is an important tool, it is not the only tool that might be used, particularly by investors, when determining the probability of long-term success of an entrepreneurial venture.
BDC Staff. (n.d.). 4 Ways to Assess Your Business Performance Using Financial Ratios. (Business Development Bank Canada) Retrieved September 29, 2017, from bdc.ca: https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4-ways-assess-business.aspx
Peavler, R. (2017, February 28). Limitations of Ratio Analysis. Retrieved September 30, 2017, from thebalance.com: https://www.thebalance.com/limitations-of-financial-ratio-analysis-393236
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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David Harkins is a business strategist, speaker, and teacher.
He is the founder and executive consultant at David Harkins Company. In his spare time, he writes hikes, explores, and creates art. Although, not necessarily in that order.
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