These are the financial green flags for investors to look for.
Startup investing is a high-risk, high-reward game with significant returns and portfolio diversification potential. Backing a firm with high potential could yield between 5x to 100 times the returns on your investment. On the contrary, investing in an unstable business may leave you with empty pockets.
So, how can you discern whether the company you’re considering is flourishing or floundering? It boils down to your ability to spot the right cues.
Here are seven things to consider to ensure a startup is on the right track.
1. Revenue is growing
The profit-and-loss statements of the company depict a steady increase in the revenue month-over-month and year-over-year. It doesn’t have to be a massive spike in profitability, but even a modest rise in revenue indicates a solid financial outlook.
2. Steady cash flow
The firm has consistently positive cash flow from operational activities, indicating its ability to generate cash through its primary business operations.
3. Expenses are staying flat
In conjunction with revenue growth, the firm’s expenses should stay flat, or if increasing, they should be rising in tandem with the increase in revenue.
4. Good cash balance
The firm maintains a healthy reserve of cash to meet unexpected expenses. Besides, it can easily cover short-term and long-term needs without borrowing or taking out additional loans.
5. Activity ratios are in-line
Activity ratios measure how efficiently a business uses its resources to generate revenues and cash. Common activity ratios include accounts receivable turnover ratio, merchandise inventory turnover ratios, and total assets turnover ratios.
As a general rule of thumb, the higher these ratios, the better — as it signals the firm can generate more revenue with fewer assets.
6. New clients and repeat customers
Acquiring new clients costs five to ten times higher than working with the same customers again. A steady stream of new and return buyers exhibits that the business has multiple options for generating revenue.
A financially sound business is built on customer retention and constantly works towards serving people better.
7. Debt ratios are low
The debt ratio is the ratio of total debt to total assets. For a given company, this ratio reveals whether it has loans and, if so, how its credit financing compares to its assets. A financially healthy company balances its debt-to-equity ratio (0.4 or lower) and maintains a healthy interest coverage ratio.
The final word
When investing in startups, success lies in spotting the next big thing and avoiding potential pitfalls. Even though a startup may have exhibited the signs of a healthy business, what looks good on paper may not translate to the real world. Take the time to execute due diligence to navigate the risks and make well-informed decisions.
Want to know more about startups and what it takes to get started? Since 2006, Escalon has helped thousands of startups get off the ground with our back-office solutions for accounting, bookkeeping, taxes, HR, payroll, insurance, and recruiting — and we can help yours, too. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.