Five Ratios that Business Executives Need to Understand
Executives need to understand that ratios are derived from the key components of a business’s financial statements and those ratios need to be viewed as a system that interrelates a business’s financial statements and operations.
Ratio 1 – Gross Margin Percent: All businesses have different expenses that total up to cost of goods sold (COGS), but the Gross Margin Percent provides a clear relationship between a business’s revenue and their cost of goods sold.
Ratio 2 – Quick Ratio (Acid Test) is a ratio that measures if a business has enough current assets, excluding inventory and prepaid(s) to cover its current liabilities (accounts payable, accrued payroll, lease payments) that need to be paid timely. A business needs to have a Quick Ratio > 1 to show liquidity.
Ratio 3 – Days Sales Outstanding (DSO) is a working capital ratio that measures the average number of days that a business takes to collect a customer invoice (sales on credit into cash). A low DSO number shows that a business is collecting their accounts receivable timely, while a high DSO number shows that a business is taking a longer time to turn its accounts receivable (sales made on credit) into cash.
Ratio 4 – Interest Coverage is a ratio used by lenders, which is generally part of a business’s bank loan covenants, to determine if there is enough operating income (earnings before interest and taxes) to pay the interest payments on a business’s debt.
Ratio 5 – Net Profit Percent is a ratio that shows how much profit a business really earned (net revenues after all expenses have be deducted). Net Profit Percent can show if a business is operating properly, including if a business’s revenues and costs are stable, costs are increasing more than revenues, or revenues are increasing more than costs.
Though all businesses are different, there are key ratios that help show if a business is generating cash timely, operating properly, and is profitable. There are industry specific ratios and then there are general ratios that all businesses have in common and executives need to review their business’s ratios on a monthly basis.