Finance Business

Critical Financial Performance Ratios to Track a Start-up’s Liquidity, Profitability, and Solvency

The foundation of financial analysis, planning and decision-making is financial statements that majorly consist of Balance Sheet and Profit and Loss Account. While the profit & loss account shows the operating activities of a business entity, the balance sheet depicts the value of the assets acquired and of liabilities as at a particular point in time.

But, the above yearly statements fail to disclose all of the necessary and relevant information. In order to obtain the material, significant and relevant information required for ascertaining the financial strengths and weaknesses of a business start-up, it is important to analyze the data depicted in the financial statements.

Meaning of financial performance ratios

A ratio refers to “the indicated quotient of two mathematical expressions and as the relationship between two or more things.” Here, financial performance ratios or accounting ratios represent a mathematical expression of the relationship between accounting figures stated in the financial statements, which are connected with each other in some logical manner.

The analysis of financial performance ratios is based on the ground that a single accounting figure by itself might not communicate any meaningful information to the users. However, when it is expressed relative to some other figure, it can definitely provide some significant information.

Assessment of business performance through ratio analysis

When it comes to the sustainable growth of a start-up enterprise, it becomes of utmost importance to understand the health of the business firm. Here, the financial performance ratios tell us how healthy and financially viable a start-up firm is.

A sought-after technique of analyzing the performance of a start-up business concern or other established enterprise is that of financial ratio analysis. It is construed as a tool of financial management and attains crucial significance. The feature which accentuates the application of financial ratio analysis is that it presents facts on a comparative basis and enables drawing of inferences regarding the overall performance of a business.

It must be noted that the analysis of financial performance ratios is not just comparing different figures from the balance sheet, income statement, and cash flow statement. It also comprises the comparison of the numbers against previous years, other companies, the industry, or even the economy in general for the ultimate purpose of financial analysis.

The objective of financial performance ratios

The main objective of financial performance ratios is that all stakeholders (owners, investors, lenders, employees, etc.) can draw valuable conclusions about the following:

• Performance of the start-up or established business (past, present and future);
• Strengths & weaknesses of such firm; and
• Ability to take rational decisions in relation to such firm

The usefulness of financial performance ratios

Financial Statement analysis with the aid of financial performance ratios is useful to various stakeholders to obtain the desired information about the start-up or other business entity. For instance,

• Shareholders or owners of the entity are interested to know about the firm’s profitability and growth.
• Investors are interested to know about the firm’s financial health, particularly the future perspective of the organization.
• Lenders and creditors keep an eye on the safety perspective of their money lent to the entity. As such, they are interested in knowing whether the business entity will be able to pay their dues on the due date.
• Employees/workers are also interested to know about the financial wealth of the start-up organization and compare it with the competitor company.
• Government authorities and regulators will also analyze the financial statements to determine taxation and other statutory sums payable to the Government.

Sources of computing financial performance ratios

The sources of information for financial statement analysis are:

1. Annual Reports
2. The Institute of Chartered Accountants of India
3. Financial Management
4. Interim financial statements
5. Notes to Accounts
6. Statement of cash flows
7. Business periodicals
8. Credit and investment advisory services

Types of financial performance ratios

There are four major categories of financial performance ratios which are as under:

Liquidity Ratios/Short-term solvency ratios

Liquidity or short-term solvency is concerned with the ability of the start-up or other established entity to pay its short-term liabilities. The inability to pay-off short-term liabilities influences its credibility as well as its credit rating. Also, continuous default on the part of the enterprise leads to the situation of commercial bankruptcy, which may eventually cause its sickness and dissolution. Short-term lenders and business creditors are very interested in knowing the state of liquidity of the business because of their financial stake. Some of the important financial performance ratios used to assess the liquidity position of start-ups and other businesses include:

Liquidity Ratios and How are they calculated?

• Current Ratio  = Current Assets ÷ Current Liabilities

Interpretation: It is one of the most common measures of short-term liquidity. It answers the question that whether your business has adequate current assets to satisfy the payment schedule of its current debts with a margin of safety for possible losses.

• Quick Ratio  = Quick Assets ÷ Current Liabilities

Quick Assets = Current Assets − Inventories − Prepaid expenses

Interpretation: This ratio is a much more conservative measure of short-term liquidity than the current ratio. As quick assets comprise only cash and near-cash assets, this ratio indicates the start-up’s ability to instantly use its near-cash assets to pay down its current liabilities as and when they fall due.

• Net Working Capital Ratio = Current Assets – Current Liabilities (Excluding short-term bank borrowing)

Interpretation: It acts more as a measure of cash flow than a ratio. The outcome of this calculation must be a positive number. Bankers often look at ‘Net Working Capital’ over time to determine a company’s capability to face financial crises and loans are often tied to minimum working capital requirements.

Leverage Ratio/Long-term solvency ratios

The leverage ratios are referred to as those financial performance ratios that measure the long-term stability and capital structure of the start-up firm or other business entities. Such ratios indicate the mix of funds provided by owners and outside lenders and assure the lenders of the long-term funds in respect of:

• Periodic payment of interest during the tenure of the loan, and
• Repayment of principal amount on the maturity

These ratios offer an insight into the financing techniques adopted by a start-up business, and, as a consequence, focus on the long-term solvency position. Some of the important financial performance ratios used to assess the long-term solvency position of start-ups and other mature businesses include:

Leverage Ratios and How are they calculated?

• Equity Ratio = Shareholders’ Equity ÷ Capital Employed

Interpretation: It depicts the proportion of owners’ funds to the total capital fund invested in the start-up or other business. It is believed that the higher the proportion of shareholders’ fund, the lower is the degree of risk.

• Debt to Equity Ratio = Total Outside Liabilities/Total Debt ÷ Shareholders’ Equity

Interpretation: It is used to analyze the long-term solvency of a business firm. A high debt to equity ratio means less protection for creditors, and a low ratio, on the other hand, signifies a wider safety cushion. This ratio is very often referred to in capital structure decisions and is also used by lenders as it shows relative weights of debt and equity.

Shareholders’ equity = Equity and preference share capital + post accumulated profits (excluding fictitious assets etc.)

• Capital Gearing Ratio = (Preference Share Capital + Debentures + Other Borrowed funds) ÷ (Equity Share Capital + Reserves & Surplus – Losses)

Interpretation: In addition to the debt-equity ratio, many a time capital gearing ratio is also computed to showcase the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders or net worth.

• Interest Coverage Ratio = Earnings before interest and taxes ÷ Interest

Interpretation: It shows the firm’s ability to service the fixed liabilities, i.e., by establishing a relationship between fixed claims and what is normally available out of which such claims need to be paid. This ratio shows the extent to which EBIT may fall without causing any embarrassment to the entity regarding the payment of fixed interest charges.

Activity Ratios/Efficiency Ratios/Performance Ratios/Turnover ratios

Activity or turnover ratios are those parameters which are employed to evaluate the efficiency with which the business firm or a start-up manages and utilizes its assets. These are often also called as ‘Asset management ratios’. These ratios normally indicate the frequency of sales with respect to its assets. Such assets may be capital assets or working capital or average inventory. Some of the important financial performance ratios used to assess the degree of efficiency in the management and utilization of assets of start-ups and other businesses include:

Activity Ratios and How are they calculated?

• Capital Turnover Ratio/ Net Asset Turnover Ratio = Sales /Cost of Goods Sold ÷ Net Assets

Interpretation: It highlights the firm’s ability of generating sales/ Cost of Goods Sold per rupee of long term investment. The higher the ratio, the more efficient is the utilization of owner’s and long-term creditors’ funds. Net Assets include Net Fixed Assets and Net Current Assets (Current Assets – Current Liabilities).

• Inventory/ Stock Turnover Ratio = Sales /Cost of Goods Sold ÷ Average Inventory

Interpretation: This ratio establishes the relationship between the cost of goods sold during the year and average inventory held during the year. It measures the efficiency with which a start-up firm utilizes or manages its inventory. It shows how fast inventory is used or sold. A high ratio is preferred from the view point of liquidity and vice versa. A low ratio means that inventory is not used/ sold and remains in the warehouse for a long time.

• Receivables (Debtors) Turnover Ratio = Credit Sales ÷ Average Accounts Receivables

Interpretation: The speed with which accounts receivables are collected impacts the liquidity position of the business firm. This ratio throws light on the collection and credit policies of the entity. It captures the efficiency with which management is managing its accounts receivables.

• Payables (Creditors) Turnover Ratio = Annual Net Credit Purchases ÷ Average Accounts Payables

Interpretation: This ratio shows the velocity of payables payment by the business enterprise. A low creditor’s turnover ratio showcases liberal credit terms granted by suppliers, whereas a high ratio shows that creditors’ accounts are settled rapidly.

Profitability Ratios

The profitability ratios capture the profitability or the operational efficiency of the start-up firm or other mature business enterprise. These ratios reflect the final results of business operations, and are; therefore, some of the most closely watched and widely quoted ratios. The business management attempts to maximize these ratios in order to maximize firm value. The business results may be assessed in terms of its earnings with reference to a given level of assets or sales or owner’s interest, etc. Some of the important financial performance ratios used to assess the degree of profitability of start-ups and other businesses include:

Profitability Ratios and How are they calculated?

• Net Profit Ratio = {Net Profit or EAT ÷ Sales} × 100

Interpretation: This ratio envisages the relationship between net profit and sales of the start-up entity. It identifies the proportion of revenue that makes its way into profits. A high net profit ratio shall assure positive returns of the enterprise.

• Return on Investments (ROI) = {Return /Profit /Earnings ÷ Investment} × 100

Interpretation: ROI is the most significant profitability ratio, which depicts the percentage of an overall return on funds invested in the start-up business by its owners. It measures the overall return of the business on investment/ equity funds/capital employed/ assets.

• Return of Capital Employed (ROCE) (post-tax) = {EBIT(1 – t) ÷ Capital Employed} × 100

Interpretation: It is just another variation of ROI. ROCE must always be higher than the rate at which the enterprise borrows. Capital employed implies nothing but Net worth plus Debt. It tells the owners whether or not all the effort put into the business has been worthwhile.

• Earnings per Share (EPS) = {Net profit available to equity shareholders ÷ Number of equity shares outstanding}

Interpretation: EPS denotes the overall profit derived for each share in existence over a particular period. The firm’s profitability from the point of view of ordinary shareholders can be appraised in terms of earnings on per share basis.

• Price Earnings (P/E) Ratio = {Market Price per Share (MPS) ÷ Earnings per Share (EPS)}

Interpretation: At any point in time, the P/E ratio is a parameter of how highly the market accords value to a business. It indicates the expectations of equity investors about the earnings of the entity. It relates earnings to market price and is usually considered as a holistic measure of the growth potential of an investment, risk characteristics, shareholders orientation, corporate image and degree of liquidity.

Takeaway

Financial performance ratios are relevant in assessing the performance of a start-up firm or other mature entity in respect of the following aspects:

• Liquidity Position
• Long-term Solvency
• Operating Efficiency
• Overall Profitability
• Inter-firm Comparison
• Planning and Budgeting

No business can succeed without proper planning and budgeting. Financial analysis through ratios is a step towards evaluating the overall business performance. We at Enterslice, have a team of expert financial analysts who can help you assess the business performance of your organisation to assist you in long-term growth planning.