You’re an entrepreneur – and hopefully, a successful one. But how is your Accounting IQ?
Over the last 15 years at Laurentian, we’ve worked with many technology firms, from bootstrapping, entrepreneurial startups to successful, midsize companies. Our experience working with many tech founders and executives over this time has shown us just how helpful it can be when they’re familiar with what we call Entrepreneurial Accounting.
What’s Entrepreneurial Accounting? In a nutshell, it includes some fundamental accounting metrics that are important for all entrepreneurs to know, in addition to some newer, tech-specific metrics that help to illustrate specifically how tech startups are performing.
With this in mind, we’ve put together a two-part blog post focused on these two distinct parts of Entrepreneurial Accounting. This first part addresses the fundamentals that are relevant to all companies, and the second part looks at the newer accounting metrics that can be critical for demonstrating the financial health of tech startups.
Just to be clear, there are innumerable accounting concepts and principles of accounting that would be very useful for founders and executives of tech startups to be familiar with. That said, our goal today is to review just three of the most important types of metrics. Knowing profitability ratios, liquidity ratios, and performance ratios will help you better understand the financial health of your company, and this will help you make better business decisions to ensure its long-term success.
As you might have guessed, profitability ratios help you track the profitability of your company. We’re going to look at two of these ratios: gross profit margin and net profit margin. These two ratios work together to illuminate profitability from different angles. This is important because without both perspectives, you may not have visibility into a critical issue affecting your company’s profitability.
For example, you may be under the impression that all sales revenue is the same, even though some products and services are more profitable than others. If your products or services have varying degrees of profitability (and most do), then all sales revenue is not equal in your business. And you should be keenly aware of that. For Software as a Service (SAAS) firms, subscription revenue will typically be your most profitable revenue item since that is the main business line. Associated items such as professional services tend to carry lower margins.
Gross Profit Margin: This is a company’s revenue minus its total direct costs involved in producing the product or delivering the service, divided by revenue. This shows what percentage of sales is left over after direct costs, and it’s an important measure of efficiency. Understanding this can help provide guidance to you as to when you need to adjust prices or volume in order to keep more of what you sell.
As an example, let’s say Company XYZ’s revenue for a quarter is $250,000, and that its direct costs for those sales was $60,000. Subtracting the direct costs from the revenue results in $190,000. Dividing $190,000 by $250,000 gives us 76% for XYZ’s gross profit margin. That sounds like a healthy margin, but it’s actually a little less than the 80-85% that many software companies aim for. And, of course, it’s just the gross profit margin. For the rest of the story, it’s important to figure out the net profit margin, as seen below.
Net Profit Margin: This is a company’s net profit measured against revenue. Unlike gross profit margin, it takes into account all expenses related to the business (such as marketing, rent and other general overhead), and not just the direct costs involved in producing the product. This margin tells you how much of every dollar in revenue your firm is able to keep after all expenses are paid.
Continuing our example with Company XYZ, we know that its direct costs are $60,000. Let’s assume that all other expenses related to the business for the quarter are $80,000. Adding that to the direct costs gives us $140,000, which we subtract from $250,000 to give us a net profit of $110,000. By dividing that figure by total revenue, $250,000, we get 44%, which is XYZ’s net profit margin. That’s in a healthy range for a SAAS company. (For more thoughts on that topic, you may want to read investor Brad Feld’s post, “The Rule of 40% for a Healthy SaaS Company.”)
Every company’s founders and executives should track these metrics on a monthly basis, as it will give them a critical sense as to whether they’re running a profitable business. Also, comparing your company’s margins to your industry averages can provide you with a strong indication as to how well your company is doing compared to your competitors.
Liquidity ratios are critical because they help determine how well the company can meet its obligations. Cash flow problems are one of the biggest – and most common – issues that tech companies face. In a nutshell, it’s not fun when you can’t make payroll because of a cash crunch. Liquidity ratios allow you to track how you’re managing your cash.
The Current Ratio is a company’s current assets divided by current liabilities. It shows whether the assets that you can convert into cash quickly (within a year) will cover what you must pay off soon (also defined as within a year). A ratio of less than 1.0 means that you might run out of cash within the next year unless you’re able to generate additional cash. It’s a simple and powerful metric, but it does have some limitations. For example, including inventory in the calculation may provide a distorted view of the company’s ability to generate cash in the short-term. Given that SAAS firms generally do not carry physical products, this may not be the preferred metric for them.
The Quick Ratio consists of a company’s cash plus accounts receivable divided by current liabilities. Unlike the current ratio, this ratio excludes inventory and is therefore a more meaningful measure of how likely a company can meet its obligations. The idea for this is that inventory usually takes longer to turn into cash so we exclude it from this calculation. At Laurentian, we prefer using the quick ratio for our tech firms as it give us a quick and easy “acid test” of their liquidity.
It’s also important to carefully budget expenses, as one large, unexpected expense could severely impact a company’s ability to pay its bills. We have seen some firms run into problems when they don’t pay close attention to their cash forecasts.
Accounts Payable Days: Company’s accounts payable divided by cost of goods sold, multiplied by 365 days. Higher numbers are generally better. Lower numbers indicate the company may be paying their suppliers too quickly.
Accounts Receivable Days: Company’s accounts receivable divided by sales multiplied by 365 days. Lower numbers are generally better. Higher numbers indicate the company may not be receiving payments quickly enough from their customers. But this too, will vary dramatically by industry. We find that collecting fees upfront either on a monthly, quarterly or annual basis is a desirable practice in managing cash flow. Getting customers to pay upfront (without having to discount too much) can help delay the need for additional sources of funding and avoid the need to give up additional equity.
Performance ratios help determine how efficiently the firm’s management uses each dollar invested.
The Return on Equity Ratio, also known as return on net worth, is a company’s net income divided by its Shareholder’s Equity (sometimes called Owner’s Equity). This ratio shows how profitable a company is with the money shareholders have invested. Generally speaking, a company with $5 million in sales and only $10 million in invested capital is more valuable than a similar company with the same $5 million in sales but with $30 million in invested capital.
A company’s Return on Investment Ratio is the firm’s total return from an investment less the cost of the investment divided by the cost of the investment. It shows the efficiency of an investment compared against similar investments. This is frequently used for specific products or marketing campaigns.
The Debt to Equity Ratio is found by dividing a company’s total liabilities by its total assets. This shows a company’s total financial leverage or financial riskiness. It depends on the industry, but a ratio of 0 to 1.5 would be considered good, while anything over that would be considered not so good. The judicious use of debt can be a good thing as it decreases the company’s overall cost of capital. It also reduces the need for more expensive equity. The key for any firm is to be very sure the cash flow can cover the debt repayments.
With a solid understanding of these three types of ratios – profitability, liquidity, and performance – an entrepreneur will be much better positioned to understand their company’s financial health and be able to spot any potential threats to its profitability and growth. Look next quarter for Part 2 of this post, in which we’ll discuss a few of the newer financial metrics that have become critical to judging the financial health of SAAS companies.
Written by Gerry Preville and Prasanna Janaswamy