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 1.2 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 - Prepaid Expenses) ÷ 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. A high debt to equity ratio signals financial weakness, risk, and an over reliance on debt which is often unsustainable.
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
When it comes to a balance sheet, the most important metrics are really the most common sense. We should care very much about Total Assets, Total Liabilities, and Shareholder's Equity. Shareholder's Equity is simply Total Assets minus Total Liabilities.
What questions can a balance sheet help answer? ›
The balance sheet can help users answer questions such as whether the company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and whether the company is highly indebted relative to its peers.
What are good ratios for a balance sheet? ›
Most analysts prefer would consider a ratio of 1.2 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.
What are the three most important financial metrics? ›
What are the top 3 key financial metrics in any company? There are 3 top financial metrics that are important in every company: revenue, net profit, and burn rate.
How to tell if a company is financially healthy? ›
A financially healthy company typically has sufficient cash flow to cover its expenses and debts, generates consistent profits, maintains manageable debt levels, and possesses valuable assets.
How to measure a strong balance sheet? ›
The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital, or short-term liquidity, asset performance, and capitalization structure. Capitalization structure is the amount of debt versus equity that a company has on its balance sheet.
What does a healthy balance sheet look like? ›
A balance sheet should show you all the assets acquired since the company was born, as well as all the liabilities. It is based on a double-entry accounting system, which ensures that equals the sum of liabilities and equity. In a healthy company, assets will be larger than liabilities, and you will have equity.
How to read a balance sheet for dummies? ›
Assets are on the top of a balance sheet, and below them are the company's liabilities, and below that is shareholders' equity. A balance sheet is also always in balance, where the value of the assets equals the combined value of the liabilities and shareholders' equity.
What is the most important part of 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 balance sheet answer key? ›
A balance sheet is a financial statement that contains details of a company's assets or liabilities at a specific point in time. It is one of the three core financial statements (income statement and cash flow statement being the other two) used for evaluating the performance of a business.
A healthy current ratio is normally between 1.5 and 2, but this can vary depending on the industry in which your company operates. A current ratio indicates whether a corporation has enough cash flow to cover its immediate debts and liabilities, if necessary.
What are the three main ways to analyze financial statements? ›
Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow statement, which form the basis for financial statement analysis. Horizontal, vertical, and ratio analysis are three techniques that analysts use when analyzing financial statements.
What are the 5 profitability ratios? ›
Profitability Ratios:
- Return on Equity = Profit After tax / Net worth, = 3044/19802. ...
- Earnings Per share = Net Profit / Total no of shares outstanding = 3044/2346. ...
- Return on Capital Employed = ...
- Return on Assets = Net Profit / Total Assets = 3044/30011. ...
- Gross Profit = Gross Profit / sales * 100.
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 the most important number on a balance sheet? ›
One very important number is Retained Earnings. This is our accumulated earnings balance. In the above example, it is the net profit for the year, i.e. $293,768. At the end of the second year, this would be the net profit for the second year added to the retained earnings balance at the end of the first year.
What is the most important metric for a business? ›
Four critical metrics every business must track
- Sales Revenue. One of the most obvious metrics your business must track is sales revenue. ...
- Monthly Profit or Loss. Another typical metric businesses measure is monthly profit and loss. ...
- Customer Attrition. ...
- Customer Retention.
Many different financial ratios can help evaluate a company in the financial services sector, two of the best metrics are the price-to-book (P/B) ratio and the price-to-earnings (P/E) ratio.
