Balance sheet ratios
/What are the Ratios for Analyzing a Balance Sheet?
A balance sheet shows the financial position of a business as of the end of a reporting period. The information it contains can be used to derive a number of ratios that can be used to infer the liquidity, efficiency, and financial structure of a business. The following list includes the most common ratios used to analyze the balance sheet.
Liquidity Ratios
Liquidity ratios allow you to discern the ability of a business to pay off its obligations. These ratios are used by creditors and lenders to decide whether it makes sense to extend credit to a business. The main liquidity ratios are the cash ratio, current ratio, and quick ratio.
Cash Ratio
The cash ratio compares a company's most liquid assets to its current liabilities. It is the most conservative of all liquidity ratios. As such, it is most useful for evaluating whether a business can meet its immediate obligations in the near term. It is most useful when liabilities must be settled at once, as well as when a business has few other current assets. The formula for the cash ratio is:
(Cash + Cash equivalents) ÷ Current liabilities = Cash ratio
Current Ratio
The current ratio compares all current assets to all current liabilities to see if there are enough current assets to pay for current liabilities. Its main failing is that the inventory component of current assets can be difficult to sell off. It is most useful when there is a ready market for the organization’s inventory, or when there is very little inventory on hand. The formula for the current ratio is:
Current assets / Current liabilities = Current ratio
Quick Ratio
The quick ratio compares all current assets except inventory to current liabilities to see if there are sufficient assets capable of being liquidated in the near future to pay for current obligations. It is most useful when a business has a large investment in slow-moving inventory. This is probably the most effective liquidity ratio for most businesses. The formula for the quick ratio is:
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio
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Efficiency Ratios
Efficiency ratios allow you to measure the speed with which a business converts its receivables and inventory into cash, as well as the speed with which payables are paid off. These provide insights into the capabilities of a company’s management team. The main efficiency ratios are accounts receivable turnover, inventory turnover, and accounts payable turnover.
Accounts Receivable Turnover
The accounts receivable turnover ratio compares net credit sales for the year to average receivables in order to determine how quickly receivables are being collected. It is impacted by both the credit policy of a business and the aggressiveness of its collection department. It should be compared to prior period results on a trend line, to see if there are any changes in collection effectiveness over time. The formula for accounts receivable turnover is:
Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) / 2)
Inventory Turnover
The inventory turnover ratio compares the cost of goods sold for the year to average inventory in order to determine how quickly a business is selling off its inventory. A low turnover rate may indicate that a business has invested excessively in inventory. The formula for inventory turnover is:
Annual cost of goods sold / Ending inventory = Inventory turnover
Accounts Payable Turnover
The accounts payable turnover ratio compares total supplier purchases to average accounts payable in order to determine whether a business is paying its suppliers too soon or too late. The formula for accounts payable turnover is:
Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) / 2)
Financial Structure Ratios
Financial structure ratios allow you to discern whether the amount of debt carried by a business is appropriate. The main ratio is the debt to equity ratio. We also discuss the debt service coverage ratio and the interest coverage ratio.
Debt to Equity Ratio
The debt to equity ratio compares the amount of all debt to equity. A high proportion indicates that the financial structure of a business may contain too much debt, which increases the risk of bankruptcy. The formula for the debt to equity ratio is:
(Long-term debt + Short-term debt + Leases) ÷ Equity
Debt Service Coverage Ratio
The debt service coverage ratio is calculated by dividing total net annual operating income by the total of annual debt payments. This measures the ability of a business to pay back both the principal and interest portions of its debt. The formula is as follows:
Net annual operating income ÷ Total of annual loan payments = Debt service coverage ratio
For more accuracy, reduce the total debt service figure by the beneficial effect of the deductibility of interest payments on income taxes.
Interest Coverage Ratio
The interest coverage ratio is calculated by dividing earnings before interest and taxes by interest expense. The intent is to see if a business can at least pay for its interest payments when due, even if the balance of a loan cannot be repaid. This measure works well in cases where a loan is expected to be rolled over into a new loan when it reaches maturity. The calculation is as follows:
Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio