There are key performance indicators that investors and lenders will want to see in a company's financial statements before they will invest or loan to the business. Investors will be looking at these key metrics, so work with your controller services to track and improve them. Business financial statements are like a financial report card showing how well your business is doing.
Key Takeaways
- Financial statements reveal information about a company, including its net profit or the revenue remaining after paying all expenses.
- Sales and revenue growth are critical to a company's financial performance and determining if sales have increased or decreased.
- Investors want to see healthy profit margins, which represent the percentage of profit earned on each dollar of revenue.
- Companies need adequate cash flow to run their daily operations, making free cash flow a key metric for lenders and investors.
Net Profit
Financial statements will reveal a company's net profit, The net profit is the money that a business has left over after paying all expenses. "Are you making money?" is often the first question asked, but it's only a starting point. Unsustainable profits are bad, and losses can be good if you're on track to profitability as you scale up. But as many business owners do not often have a clear understanding of their net profit, this is a good place to start.
Sales
You may have an objectively amazing product or service, but the real question is, are people willing to buy it? If you establish a track record of sales before seeking investment, investors don't take on the risk of not knowing the answer to that question. Investors also care about sales growth. Are you showing an upward trend, or did the initial excitement fizzle out?
Margins
Sales are meaningless if you aren't making money. Investors also want to see your profit margins both overall and at the individual product level.
They'll also compare your margins against industry standards and their other available investment opportunities. Higher margins generally lead to a better return for investors.
If you have low margins, you'll need to demonstrate a plan for improving them. For early-stage businesses, demonstrating how economies of scale will reduce costs as you grow is usually the answer.
Note
It's critical to compare a company's financial statements to companies within the same industry to show how well the company is performing against its peers. For example, banks should be compared to those in the financial sector, while technology companies with those in the tech sector.
Cash Flow
In business, cash is king. A solid five-year plan does you no good if all your employees will walk out if you can't make payroll next week.
Investors view of cash in the bank as a sign that you can deal with unexpected problems and capitalize on new opportunities. Free cash flow, the amount of cash that's left after you meet your expenses each period, is a sign of sustainable operations. If you have both, investors won't have to worry that you could go under at any time.
Customer Acquisition Cost
Customer acquisition cost tells how much you have to spend to get one new customer. It's calculated by dividing your marketing spend by your number of new customers. For a fledgling business, this can sometimes be a very large number. For businesses that are mostly established, this amount can be blended and reduced by repeat and referred customers, who are likely easier to acquire.
Acquisition cost is important because a product that's profitable from a material and labor standpoint may not actually be profitable if you have trouble getting people to buy it. This problem can occur with super-niche areas where it's hard to spread the word about your product or in hyper-competitive areas where advertising competition is fierce.
As with other measures, your ability to find economies of scale or otherwise lower the cost can be more important than the actual number.
Note
Investors want to see a company's growth potential and its level of financial stability. Investors also use financial statements to determine whether the CEO and management team have a consistent track record of generating sales, revenue, and profit over multiple quarters and years.
Customer Churn Rates
Coupled with the acquisition cost is your churn rate. Once you get customers, can you keep them? A low churn rate can compensate for a high acquisition cost, and it's often an indicator of less risk for investors if you have steady repeat business. Of course, high churn rates may be the norm in sectors with long purchase cycles and/or heavy competition.
Debt
Debt scares investors for two reasons. One is simply that if you go out of business, debt holders get their money back before equity holders have a chance to claim what's left.
The second, and more important, is that debt payments eat up your cash. High debt payments can hinder your ability to meet payroll and other expenses during slow periods. They may also mean you have less cash available to help you handle a sudden surge in orders or an emergency equipment replacement.
One of the most common debt measures is the quick debt ratio—current assets (excluding inventory) divided by current liabilities. A quick ratio of 1 indicates that you can exactly meet your obligations, and the higher it is above that, the more flexibility you have.
Accounts Receivable Turnover
Accounts receivables turnover shows how long it takes you to collect money from customers. This tells investors two important things.
First, are you willing to do what's necessary to make sure you get paid? Many new business owners feel bad asking for money and end up never getting paid. An investor looking for a return doesn't want to work with someone who isn't good at tracking down customer payments.
Second, how stable are your customers? A slow turnover combined with a large percentage of write-offs could indicate that many of your customers don't have financially sound operations. This adds risk to your business model, and investors will want to see an increased return to compensate.
Break-Even Point
Investors accept short-term losses, but they want to see a profit and a return on their investment sooner rather than later. Your break-even point says what is needed to make this happen.
Often, the break-even point is a specific sales target that will cover your expenses and get you to profitability. You may also build on other assumptions, such as economies of scale, improved production efficiency, or reduced marketing expenses, as long as you can explain them in a way that's acceptable to investors.
Personal Investment
You deserve sweat equity for the hard work it took to get your business running, but many investors will want to see that you've made a financial equity investment as well. If you have money at stake, investors believe that you'll do what it takes to protect it. If you're not at risk of losing financial capital, investors may fear that you'll view them as a blank checkbook and burn through cash without enough focus on protecting their investments.
You can discuss the specific ratios that apply in each category of analysis with your controller services. Even if you're not ready to seek investment, finding ways to improve can help the overall health of your business.
Frequently Asked Questions (FAQs)
What are some things you look for in financial statements as an investor?
When analyzing financial statements, investors should consider reviewing a company's net profit, sales and revenue growth, debt level, profit margin, and free cash flow.
How are financial statements helpful in making investment decisions?
Financial statements reveal critical pieces of information about a company's ability to generate revenue from its sales. Financial statements also show how well a company is managed by controlling costs and using its debt properly to expand or reinvest back into the company to generate profit.
What happens when an investor is misled by financial statements?
Companies may mislead investors by misrepresenting their financial performance by inflating revenue and earnings or understating costs to hide problems or reduce their taxable income. If a company has accounting errors that lead to restating lower earnings, shareholders can lose money when the stock price plunges.
How do investors use financial statements?
Investors use financial statements to determine the financial viability of a company by analyzing its revenue, profit, expenses, and debt. However, it's important that investors compare a company's financial statements with other companies within the same industry to determine how well the company is performing against its peers or competitors.
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