What is the Balance Sheet Ratio Analysis?
Balance sheet ratio indicates relationship between two items of balance sheet or analysis of balance sheet items to interpret company’s results on quantitative basis and following balance sheet ratios are financial ratio which include debt to equity ratio, liquidity ratios which include cash ratio, current ratio, quick ratio and efficiency ratios which include account receivable turnover, account payable turnover, inventory turnover ratio.
These financial ratios are used to assess the expected returns, the risk associated, financial stability, etc., and majorly include balance sheet items like assets, liability, shareholders equity, etc.
Types of Balance Sheet Ratio
It can be classified into the following categories:
#1 – Efficiency Ratios
This type of Balance Sheet Ratio Analysis, i.e., efficiency ratio, is used to analyze how efficiently a company is utilizing its assets. It indicates the overall operational performance of the company.
Various efficiency ratiosEfficiency RatiosEfficiency ratios are a measure of how effectively a company manages its assets and liabilities and include formulas like asset turnover, inventory turnover, receivables turnover, and accounts payable turnover. are as follows:
Inventory Turnover Ratio
It is calculated by dividing the cost of goods soldThe Cost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. by average inventory available with the company on the balance sheet date.
The inventory turnover ratio Inventory Turnover RatioInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. indicates how fast a company’s inventory is selling. In other words, they show how many times in a year company has sold its complete inventory and replenished it in a year. A low inventory turnover ratio indicates lower sales or that the company is holding up stocks of goods that are not in demand in the market. However, a high inventory turnover ratio doesn’t necessarily indicate the healthy position of the company unless it is coupled with good sales figures.
Receivable Turnover Ratio
The receivable turnover ratio indicates how fast a company can recover its receivables from its customers. It is calculated as mentioned below:
A high receivable turnover ratio indicates that the money expected to be received by the company from its customers is stuck in credit, i.e., customers are struggling to pay the bills. Though receivable turnover needs to be analyzed in comparison to the peers of the company in the same industry since the credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy. given to customers varies from industry to industry. For example, cash and carry business will always have a less credit period in comparison to the manufacturing industry
Payables Turnover Ratio
Payables Turnover Ratio indicates how fast the company is able to pay to its creditors. It is calculated by dividing purchases by creditors as on the balance sheet date.
It indicates whether a company is paying its suppliers on time or not. Further, a low payables turnover indicates that the company is not utilizing the benefits it might get by the credit period extended to them by the suppliers. Similar to the account receivableAccount ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. turnover ratio, the Payables ratio also needs to be analyzed basis the industry the company operates in.
Asset Turnover Ratio
Asset Turnover Ratio is calculated simply by dividing the sales with the total assets of the company. It indicates how efficiently the company utilizes its assets to generate revenue.
Net Working Capital Turnover Ratio
The net working CapitalNet Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities. Ratio indicates whether the working capital of the company has been effectively utilized to generate sales.
#2 – Liquidity Ratio
This type of Balance Sheet Ratio analysis is also known as banker’s ratio. It indicates the firm’s ability to meet its short-term obligations. The liquidity ratio is industry dependent and varies majorly from industry to industry.
The Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities indicates how readily a company can liquidate its current assets to pay off its current liabilities. It is calculated by dividing current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. by current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc..
The current ratio ideally should be above 1.33 times. CR less than 1 may indicate that the company is raising short term funds from the market to create long term assets, thus making the diversion of funds.
The Quick Ratio is also known as the acid test ratioAcid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.. It is a more stringent way of analyzing the liquidity of a company. It is calculated as under:
Inventory is a major part of the current assets of the company; however, at the time of distress, it might not be easily convertible to cash and hence cannot be used for instant debt payor recovery.
The most conservative liquidity ratio is the cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.. Cash is the most liquid asset on the balance sheetLiquid Asset On The Balance SheetLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet. of the firm, and hence cash ratio indicates what is the percentage to which the cash present with the company covers the short obligations of the company. It is usually used for a company in distress.
#3 – Solvency Ratio
This type of Balance Sheet Ratio, i.e., Solvency ratioSolvency RatioSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business., measures a company’s ability to repay its debt obligations. It indicates whether the company is churning enough cash flow to meet its short term and long-term debt obligationLong-term Debt ObligationLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability..
The types of Solvency Ratio are as follows,
Debt to Equity Ratio
The Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. is also called financial gearingFinancial GearingFinancial gearing is the management of an organization's capital by maintaining a proper proportion of debt and equity to ensure that the firm does not suffer future challenges. It's all about determining whether to go with a stock offering or a loan.. It indicates how much equity is available to cover debt obligations.
Debt Service Coverage Ratio (DSCR)
DSCR RatioDSCR RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending. indicates the ability of a company to repay its debt obligations.
Debt to Asset Ratio
Debt to AssetDebt To AssetDebt to asset ratio is the ratio of the total debt of a company to the total assets of the company; this ratio represents the ability of a company to have the debt and also raise additional debt if necessary for the operations of the company. A company which has a total debt of $20 million out of $100 million total asset, has a ratio of 0.2 is used to analyze what portion of assets of the firm are funded by debt. A high number indicates high financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively.
#4 – Profitability Ratios
These balance sheet ratios measure the overall profitability of the business. The following are the types of Profitability Ratios.
Return on Asset
Return on Asset measures the efficiency with which total assets of the company are able to generate a net profit. A high ratio value indicates the efficient utilization of the company’s assets.
Return on Equity
Return on EquityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit. is a measure of returns that the company is generating vis-à-vis the equity invested in the firm.
This has been a guide to Balance Sheet Ratio Analysis. Here we discuss the top 4 types of Balance Sheet Ratios like Efficiency ratios, Liquidity Ratio, Solvency Ratio, & Profitability Ratios along with formulas and classifications. You can learn more about accounting from the following articles –