The Balance sheet is just like your medical report. A medical report tells you which body organ needs repair or what deficiencies you have. Similarly, the Balance sheet is a medical report of the company that gives you the yearly performance report of your company. The financial figures in the balance sheet reflect the problem areas while suggesting what needs immediate attention. This helps in taking remedial action to nip the issue in the bud and improve future performance. Therefore, Balance Sheet Ratios as a subset of ratio analysis facilitate root cause analysis which is an integral part of financial analysis. Let’s understand the below parameters to quickly analyze the balance sheet ratios:
Key Balance Sheet Ratios –
- Current ratio – Current Assets / Current Liabilities.
- The ideal Current ratio is 2: 1 which means the company has adequate short-term funds to meet its short-term obligations.
- Higher is the current ratio, the better it is but a very high ratio does not mean great financial health.
A very high current ratio would mean that current assets are far more than current liabilities, this would spike the number of debtors, who are taking a lot of time to make payments, thus inflating accounts receivables/debtors. It could also mean that the current assets are underutilized. Thus, very high ratios do not necessarily mean a financially sound company. While manufacturing firms like automobiles will mostly have a negative current ratio which means that the company is able to recover its debtors faster and has a good bargaining facility with its suppliers.
- Quick ratio – Current Assets minus Inventory / Current Liabilities.
- The ideal ratio is 1:1 which means the company has liquid funds to meet any urgent obligations.
- The higher this ratio, the better it is but within limits.
- A very high quick ratio is not good for the company. As it signals underutilization of current assets. A negative quick ratio would also not necessarily mean that the company is not performing well or is financially weak.
- Debt Equity ratio – Total debt (long term + Short term) / Tangible Net worth.
- The ideal D/E ratio is 1:1 which means the company’s debt is equal to its own funds.
- Lower is the ratio better it is.
- A Higher Debt Equity ratio means the company is borrowing more funds from outsiders which carries a fixed obligation on the company to pay interest expenses.
- A company that is debt-free is free of financial obligation but may solely be dependent upon its surplus profits to finance its expansion and growth needs.
- A company with moderate debt will be in a better position to finance its funding needs, in case of aggressive growth plans.
- Tangible Net Worth or Gearing or Leverage ratio – Total Outside Liabilities (Total debt + Current Liabilities) / Tangible Net worth.
- Higher Leverage means the company’s obligations are more compared to their own funds.
- The lower this ratio the better it is.
- Adjusted Leverage ratio – TOL + Contingent liabilities / Quasi Net worth
- Debtors Turnover ratio or days – 365 / (Sales / Debtors).
- If the Debtor’s turnover days are high, it means that the debtors are taking more time to pay back. This in turn affects the company’s payment to their creditors.
- Creditors Turnover ratio or days – 365 / (Purchases / Creditors).
- If the Creditor’s turnover days are high, it implies that the company has been delaying payments to their vendors.
- Inventory Days – 365 / (Sales / Inventory).
- Higher inventory days mean that the company is not able to turn around its stock efficiently. This in turn will affect their short-term working capital management.
- Working Capital Cycle – Inventory days + Debtors days – Creditors days.
- A Higher working capital cycle means that the company is not able to rotate or churn its working capital efficiently. This in turn will affect their payment to vendors and cash position.
- Net Working Capital Gap – Current Assets – Current Liabilities.
- A negative Net working capital gap means that the obligation of the company is higher than their short-term funds.
How do Balance sheet ratios tell about the future of a company?
If you as an analyst deep dive into balance sheet ratios and look at t carefully, they speak volumes about the future of the company.
- Yearly, the quarterly or monthly trend analysis will reveal any downtrend or issues
- A very high or very low ratio will trigger further investigation
- Forecasted trends can be formulated depending upon previous historical trends
- Budgeted values when compared with the actuals reveal deviation which is further looked into
All the balance sheet ratios help to reveal the financial health of the company. It reveals how well the company is performing, and what should be the focus areas. If any of these balance sheet ratios show very high values or very low values as against the usual ones, then further investigation is required to understand how are the financial figures impacting the company’s performance. Certain companies will have very high or low specific balance sheet ratios depending upon the nature of business, seasonal fluctuations, labor-intensive nature, etc.
In 1494, Franciscan monk Luca Pacioli created the first-ever Balance Sheet with debits & credits.
What do you think about balance sheet ratios?