There comes a time in every startup founder’s journey when you must seek out financing to prepare for the next stage of growth. But before you jump into those conversations, it’s important to take a step back and understand the specific benchmarks that lenders and investors care about.
In a recent webinar hosted with our partner Naturally Austin, our Director of Credit Keanna Vear shared the most important financial metrics that investors and lenders look at when evaluating your business. Whether your small business sells socks, chairs, or protein bars, the math is the same, and you should ensure you have a strong understanding of your business’s position before moving forward with a new partner.
Keeping track of these five metrics isn’t only helpful to secure financing and find the best lender for your growth goals — it’s essential to the overall health of your business. Let’s break them down:
1. Revenue Growth
Like most founders, you’re probably very aware of this metric early on in the business. Revenue growth is the amount of sales your company makes over a given time frame, compared to the same period in the prior year. While lenders usually look at year-over-year (YoY) growth, they’ll examine month-over-month growth if you’re a new business and don’t have yearly figures yet.
YoY growth rate validates the demand in the market for your product. If you show healthy or strong growth, lenders and investors will be more willing to have a conversation.
Here’s how growth rates are typically categorized:
- 50% and up: Strong
- 25-50%: Healthy
- 0-25%: Slow
- Negative: Poor
Slow or poor sales revenue growth means your lender will likely want to discuss further to understand what is happening within your business. But don’t worry, top-line growth can be improved.
How to improve revenue growth
There are a few ways to approach your growth rate:
- SKU expansion: Consider this avenue if your product is not a high-frequency purchase item (e.g. bedding). Complementary products and other SKU sets can help bring repeat customers and boost your revenue.
- Market expansion: Understand how your product serves a specific region and how you may adjust its marketing or sales as you expand to different geographies.
- Distribution expansion: Think about national presence and distribution through big box retailers, especially if you are a young startup currently only selling through DTC or online marketplace.
2. Unit Economics
Unit economics, otherwise known as gross margin, measures your company’s ability to generate a profit from product sales and is calculated by deducting the cost of goods sold from net revenue. Average margins vary depending on industry and distribution channel. We usually see higher margins in cosmetics and apparel, and in DTC (versus B2B).
How to improve gross margin
To reach the ideal range for your industry and distribution channel, consider the following:
- Don’t be afraid to negotiate prices down with your supplier and establish relationships with more than one supplier in order to lower your blended cost of capital.
- Diversify your sales channels or supply chain in different geographic regions.
- Keep an eye on individual SKU performance. Some SKUs can drag your gross profit margins down and may not make sense to continue producing at scale.
3. Liquidity
Liquidity refers to your company’s ability to turn its assets into cash, the main funding source for your business. Having enough cash shows that your business has sufficient operating runway and grants you control so you don’t have to rely on third parties to fund your operations.
There are two ways lenders and investors evaluate liquidity:
- Cash runway (in months): Current cash divided by average monthly burn. Once your business has about four to five months of runway, it’s important to start having conversations with your debt and equity providers. By being proactive during strong liquidity scenarios, you are likely to have smoother debt and equity negotiations and mitigate cash outflow risks.
- Quick ratio: The sum of cash and accounts receivables, divided by current liabilities. Quick ratio measures your ability to pay off short-term debts with liquid assets.
It’s natural for your liquidity levels to ebb and flow. However, you (and your lenders) should be more aware if they show steady decline rather than natural fluctuations.
How to improve liquidity
Some businesses pull the following levers in order to improve their liquidity position:
- Improve cash flow by controlling operating expenses and cash burn.
- Use a balance of debt and equity to fund growth. Debt can be used to fund a working capital gap, while equity can help extend operating runway and invest in growth initiatives.
4. Asset Efficiencies
Asset efficiencies, or how you manage outbound and inbound cash flows while buying and selling inventory, is essential for any company building a physical good. It has three components:
- DIO: Days of Inventory Outstanding, or the amount of inventory your business is holding. Having too little inventory means you might not be able to fulfill sales demand, but having too much is also a cash drain. An ideal state of 120 days or less is considered healthy.
- DSO: Days of Sales Outstanding, or how long it takes for your business to collect revenue for your customers. DTC sellers see a DSO of zero days, but if you’re working with a distributor or retailer, they typically require payment terms of 30 to 60 days. The lower the DSO, the better. 60 days or less is considered healthy.
- DPO: Days of Payables Outstanding, or the sum of payments that your business owes its vendors. If your DPO is too high, that means you’re not paying vendors on time and could jeopardize your relationship with them. A DPO that is too low, means you may not have favorable payment terms with your supplier and could cause cash constraints when procuring inventory. A DPO of 120 days or less is considered healthy.
These three components make up what is known as the Cash Conversion Cycle (CCC). CCC is the number of days it takes for your company to convert the cash it spends on inventory back into cash by selling products. It can be calculated using the equation below:
CCC = DIO + DSO - DPO
- 0-60 days: Fast
- 60-120 days: Average
- 120+ days: Long
Ideally, your CCC should be zero, which means that you’re paying vendors at the exact time that you’re collecting cash from customers. The reality, however, is that distributor payment terms and other factors may force an elongated CCC period. Working capital lenders like Settle can help lower your CCC by bridging the timing gap by paying your vendors when bills are due and collecting payment when you are paid by your customers.
For more on the Cash Conversion Cycle, read our in-depth blog post.
5. Leverage
Finally, leverage is the ratio of debt to equity used to finance your company’s assets. Both debt and equity are important pieces of scaling a business, but challenges arise if the scale tips too much in either direction. Too high of a debt-to-equity ratio presents the possibility that you may not be able to repay debt in the future. Too much equity, on the other hand, means you lose ownership in your business.
A healthy ratio means debt and equity are about equal:
- 1.0 or less: Lower risk
- 1-2: Moderate risk
- 2+: Higher risk
How to improve leverage
- Debt isn’t bad — it’s necessary to grow and scale. Just be mindful of how much you take and how you plan to repay it. Some debt providers are able to give a large amount of capital for a low APR, but this isn’t always the best solution.
- Maintain positive equity. If your debts outweigh assets, your company must either raise more capital or generate free cash flow to repay it in the future.
What’s next
Now that you know what core metrics matter most, it’s time to find your next financing partner. Whether you go with a traditional bank, a modern financing solution like Settle, or venture capital, remember to ask yourself, “Do my growth goals align with this lender or investor’s goals and expectations?”
Settle makes approvals in as quickly as 1-3 business days and offers competitive, transparent terms with holisitic underwriting that goes beyond just top-line sales. Its cash flow management platform is specifically built for CPG brands that combines AP automation, working capital, and purchase orders all in one powerful platform designed to help you grow your business. Get started for free a schedule a demo call with us today.
Disclaimer: The information contained in this post is not intended as, and shall not be understood or construed as, financial or legal advice. The information contained in this post is not a substitute for financial advice from a professional who is aware of the facts and circumstances of your individual situation. Regardless of anything to the contrary, nothing available in this post should be understood as a recommendation that you should not consult with a financial or legal professional to address your particular information. Settle expressly recommends that you seek advice from a professional. Settle makes no representation or warranties, expressed or implied, and expressly disclaims any and all liability that may be based on such information contained in this post. In no event shall Settle or its affiliates, agents, or employees be liable to you or anyone else for any decision made or action taken in reliance on the information contained herein.
