3 Financial Ratios Every Tech Firm Should Know
Originally published on April 1, 2016
Updated on August 15th, 2022
Technology companies like yours have long been portrayed as the business world’s leading innovators. From Apple’s “1984” breakthrough TV commercial that introduced the Macintosh to Samsung’s “Imagine” campaign for its versatile smartphones, their marketing has emphasized the groundbreaking nature of their work.
But while you find more ways to make life amazing, you still need to maintain your bottom line – which means keeping tabs on some pretty important financial ratios to ensure your security and longevity.
Whether your company is a fledgling startup or an entrenched marketplace veteran, here are the top three ratios that every tech company needs to understand and track.
Cash Ratio – This liquidity ratio measures a company’s ability to pay for something with only the cash and cash equivalents on hand. (Cash equivalents include such items as treasury bills, money market funds, checks awaiting deposit or even gift cards.) Creditors use this ratio as a snapshot to see how well you can fulfill a short-term financial obligation.
Cash Ratio = (Cash + Cash Equivalents)/Current Liabilities
Ideally this ratio should be close to even (1:1). A high cash ratio may mean that you’re keeping too much cash on hand or aren’t processing your collections well. A low ratio could indicate that you’re relying too much on sales and inventory to pay your everyday bills.
Debt-to-Equity Ratio – This ratio measures the solvency of your company and its ability to pay off long-term debts. It gives potential investors a better look at your company’s extended outlook and indicates the level of risk they might face when lending you funds.
Debt-to-Equity Ratio = Total Debt/Total Equity
There’s no concrete rule as to a good or bad debt-to-equity ratio, because this debt is often secured to further a company’s growth. It might fund research into new technology or the development of a groundbreaking product. Maybe it was used to hire more employees, purchase a larger facility or relocate to an area with a better business climate and talent pool.
All of these moves can pay off in the long run by resulting in new or better products and services that increase sales and bring in more revenue. That said, you don’t want this ratio to be too high. Otherwise the cost of this financing can outweigh the returns on your investments, and you risk going bankrupt before you can turn a profit and pay the debt back.
Gross Profit Margin – This is the measurement of gross profits earned from sales, taking into account the cost of the goods sold (but not overhead or other costs). Gross profit margin can show the ability of a company to become very profitable in the near future – a crucial indicator in particular for a startup business seeking investors.
Gross Profit Margin = (Sales – Cost of Goods Sold)/Sales
Tech firms tend to have high gross profit margins compared to other industries, especially established companies with higher brand name recognition. Software and video game companies in particular require few physical materials and smaller workforces to make their high-demand products; for example, social game maker Zynga had a 65.87% gross profit margin in Q4 of 2015. Startup tech companies won’t see numbers like this, but having even a slightly positive ratio here is a sign of potential growth.
These three ratios won’t make or break your business, but they’ll give you valuable insight on your company’s short-term and long-term health. Seeking sound financial advice will help you maintain healthy financial ratios – helping you establish better cash management practices and ensure smart growth that pays off down the road.
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