Those who are familiar with balance sheet basics know that a company's balance sheet offers a snapshot in time of a company's financial position. You can quickly view a company's cash position, its assets, as well as its short- and long-term debt obligations. However, did you know that you can better understand the financial situation of a business by performing a few quick calculations using information contained within a balance sheet?
Current Ratio
How do you know if a company has enough cash and short-term assets on hand to pay bills in the short term? Well, using the current assets and current liabilities information presented on a balance sheet, you can determine a company's current ratio. This ratio is simply calculated as follows:
Current Ratio = Current Assets ÷ Current Liabilities
Most analysts prefer would consider a ratio of 1.5 to two or higher as adequate, though how high this ratio depends upon the business in which the company operates. A higher ratio may signal that the company is accumulating cash, which may require further investigation. If the current ratio falls below one, a business may be in danger of not meeting its short-term liquidity needs.
Quick Ratio
A similarly informative balance sheet metric is a company's quick ratio. This ratio is a bit more conservative than the current ratio as it removes inventories from the calculation:
Quick Ratio = (Current Assets - Inventories) ÷ Current Liabilities
Why would an analyst remove inventories from current assets? Inventories carried on a balance sheet cannot necessarily be converted into cash at their book value. For example, some retailers will take significant markdowns to clear their inventory for a new season. In instances such as this, liquidity ratios such as the current ratio are overstated. The quick ratio is an easy way to determine whether a company is able to meet its short-term commitments with current, short-term, liquid assets on hand. A quick ratio that is better than one is generally regarded as safe, but remember that it really depends upon the industry in which the company operates.
Working Capital
The difference between current assets and current liabilities yields a company's working capital or:
Working Capital = Current Assets - Current Liabilities
Whether a working capital metric should be positive or negative is largely dependent upon the industry in which the company operates. While a positive working capital metric is desirable in certain industries, a negative working capital metric is viewed favorably in others. For example, beverage and restaurant companies tend to negotiate their terms of trade with suppliers such that payment to suppliers is due long after inventories have been converted into cash. Consumer companies with bargaining leverage, such as Walmart stores or Brazilian beverage giant AmBev, tend to operate with working capital deficits. These deficits tend to be viewed favorably by analysts and regarded as efficient use of resources.
Debt/Equity
Finally, one of the most standout ratios derived from a Balance Sheet is the debt-to-equity ratio, which is calculated as:
Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders' Equity
Just how dependent a business is upon debt can be determined with the debt-to-equity ratio. Essentially, it is a ratio of what is owed to what is owned. In most industries, a lower ratio is viewed more favorably, though a debt-to-equity ratio of zero may not be desirable, as it may indicate an inefficient capital structure.
The Bottom Line
To better understand a business's financial situation and level of solvency, you can do a few quick and easy calculations that use data found within the balance sheet. These metrics include the current ratio, quick ratio, working capital and debt-to-equity ratio. Each of these metrics' ideal value is highly dependent upon the nature of the business in which the company operates, but the numbers are telling all the same. Try using some of these ratios on a few companies' balance sheets to see what kinds of conclusions you are able to draw from them.
FAQs
Return on assets
An organization has a number of assets, such as cash, machinery, and plants. Return on assets is a measure of the efficiency with which managers are reaping profits from company assets. This is a key indicator of the overall financial health of the organization.
How to calculate balance sheet metrics? ›
Let's take an example. If a company's balance sheet shows total assets of $100,000 and total liabilities of $60,000, then its debt-to-asset ratio would be $60,000 / $100,000 = 0.6 or 60%. This means 60% of the company's asset generation and growth is financed through debt from creditors.
What are the useful ratios in balance sheet? ›
Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE). Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company's financial health.
What are the KPIs for balance sheet analysis? ›
What are the most important KPIs to analyze on a Balance Sheet? The most important Balance Sheet KPIs include the Current Ratio, Quick Ratio, Debt-to-Equity Ratio, Return on Equity (ROE), and Net Working Capital.
What are the 5 most important financial metrics? ›
The five primary types of performance indicators are profitability, leverage, valuation, liquidity and efficiency KPIs. Examples of profitability KPIs include gross and net margin and earnings per share (EPS). Efficiency KPIs include the payroll headcount ratio. Examples of liquidity KPIs are current and quick ratios.
What is the most important figure on a balance sheet? ›
Many experts believe that the most important areas on a balance sheet are cash, accounts receivable, short-term investments, property, plant, equipment, and other major liabilities.
What is a good AR to AP ratio? ›
A ratio closer to 2:1 in favor of AR indicates a healthy business, but closer to 3:1 in favor might suggest you ought to look at growing your business, or investing that money in acquisitions or other areas. However, it's important to consider your industry and specific business circ*mstances.
What are metrics in financial statements? ›
What are Financial Metrics? Financial metrics are used to evaluate and assess the financial performance, health, and stability of a company or an investment. These metrics are derived from a company's financial statements, such as the balance sheet, income statement, and cash flow statement.
What are the metrics of income statement and balance sheet? ›
Balance sheet: This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity. Income statement: This includes gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.
How to measure balance sheet risk? ›
Some of the financial ratios commonly used by investors and analysts to assess a company's financial risk level and overall financial health include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL).
Here are the most important ratios for investors to know when looking at a stock.
- Price/earnings ratio (P/E) ...
- Return on equity (ROE) ...
- Debt-to-capital ratio. ...
- Interest coverage ratio (ICR) ...
- Enterprise value to EBIT. ...
- Operating margin. ...
- Quick ratio. ...
- Bottom line.
Operating cash flow: the amount of money being generated by regular business operations. Current ratio: a measure of solvency—the total assets divided by total liabilities. Debt-to-equity ratio: a company's total liabilities divided by its shareholder equity.
What are the four solvency ratios? ›
Solvency ratios measure a company's ability to meet its future debt obligations while remaining profitable. There are four primary solvency ratios, including the interest coverage ratio, the debt-to-asset ratio, the equity ratio and the debt-to-equity ratio.
What is a good current ratio? ›
A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.
What is the best metric for valuing a company? ›
Price to Earning Ratio
Arguably one of the best stock valuation metrics, the price to earning ratio communicates how cheap or expensive a stock is. The lower the price to earning ratio is, the more undervalued a company is.
Which metric is the best indicator of a company's operating performance? ›
Net Profit Margin
It represents how much money the company made after subtracting all costs and comparing it to revenue. This is probably one of the most important metrics for operations managers in determining a company's financial health.
Which metric is the best indicator of the store's financial performance? ›
Gross margins return on investment (GMROI)
Return on investment is vital to track for a couple of reasons. It offers more nuance than just sales or profit margins. GMROI generally tracks specific products or categories rather than inventory as a whole.
What is the most important metric your business uses to measure business success? ›
1. Sales Revenue. We chose to put this metric first as it can tell a lot of things about your company. Month-over-month sales results show whether people are interested in buying your product/service, are your marketing efforts paying off, are you still in the competition, and much more.
