The "Metrics Layer" for Finance

The past few weeks of this newsletter have introduced the three core financial statements of accounting. This week I’ll explain how Finance teams use the financial statements to inform decisions with ratios.

1. What are Ratios?

Ratios (sometimes called multiples), are simple calculations using data from financial statements to inform how a business is performing. They serve as indicators for for how a business is operating, utilizing it’s assets, managing cash, and it’s valuation. 

A valuation is the assessed value of a business. Lenders, investors, and analysts will perform ratio analysis to determine what a business (or a share of the business) might be worth.

Ratios are also used internally. Executives have the same incentives as the business’s investors - to grow the value of the business. They will use the same ratios to make sure they are on target for this goal.

Ratio Strengths

Ratios are popular because they are relatively easy to calculate. They use data that comes from line items on the balance sheet or the income statement or both.

Consider the ratio Return on Assets (ROA) as an example. The formula for ROA is:

Net Profit (from the income statement) / 
avg(total assets) between the starting and ending balance sheets

Remember our coffee cart example? Say we decide to invest in a new coffee cart. How will we know whether that investment was worth it? ROA will help us answer that question.

These ratios also help with comparing to benchmarks in the industry. The reason being that the financial statements these ratios originate from are standardized by an independent set of rules called GAAP (Generally accepted accounting principles). This standardization allows investors, analysts, banks, to use ratios to compare business’ performance to their competitors and industry benchmarks.

Ratio Limitations

Ratios are not perfect. Here are some limitations:

1. Bias - Because ratios are based on GAAP-approved financial statements, they also are subject to bias. It is common for businesses to have revenues and expenses that aren’t so easy to categorize. The Accounting and Finance teams for these businesses often have to make assumptions on their financial statements for this reason.
   
   These assumptions will usually be noted in the footnotes of the financial statements. But they won’t be picked up in the ratios. It’s important to have this context before analyzing ratios.
   

2. Incomplete - Each ratio provides insight into a specific area of the business. No single ratio will tell you everything you need to know about a business. For this reason, It’s important to assess a combination of ratios to have a wholistic view.

3. Historical - Finally, ratios are all lagging indicators. These numbers reflect past performance, but do not guarantee future performance. To have an idea of future performance, you’ll need to forecast. But that’s another topic for another day.

Different Types of Ratios

There are different types of ratios. Each type of ratio tells you something different about the business. The figure below lists some the ratio types that are most often used.

We’ll dive deeper into the use cases for each type of ratio in the coming weeks.

2. Are “Metrics” and Ratios the Same Thing?

The Data world helps businesses make decisions with metrics. But the financial world has been doing this with ratios for as long as financial statements have existed.

What does this mean for data? Only good news. At least in my opinion.

Data has two things working in their favor:

1. A model for using numbers to make decisions - ratios are proof that businesses are very much data-driven. Data teams should work with this energy not against it (i.e. don’t compete with the Finance team).
   

2. Financial data is limited. Data teams are unlimited. - Financial data is historical. Ratios may tell a story about what’s going on, but they don’t provide recommendations on how to impact them. This is where data teams have an advantage.

Ratios can help data teams understand the priorities for the business. Metrics guide data teams to deliver insights that cater to these priorities. But it’s critical to understand what the ratios mean and which ratios the business cares about first.

3. Why Ratios Matter to the Business

Financial ratios put the financial statements into action.

It’s critical to make sure the balance sheet balances.

You want to make sure the business is heading towards profitability.

And you need to make sure there’s enough cash in the bank.

But the financial statements alone don’t provide visibility into how a business is performing over time, or compared to its competitors. The financial statements are simply building blocks that Finance teams can use to assess the efficiency and valuation of their business.

At the end of the day, someone or some group has made a bet that your business will eventually be a profit-producing machine. They are waiting for that machine to be worth more than what it was when they invested.

Ratios help businesses make sure they are on the right track to accomplish this goal.