What Are Balance Sheet Ratios?
Balance sheet ratio indicates the relationship between two items of the balance sheet or analysis of balance sheet items to interpret a company’s results on a quantitative basis. and following balance sheet.
They are financial ratio which includes debt to equity ratio, liquidity ratios which include cash ratio, current ratio, quick ratio and efficiency ratios which include account receivable turnover, payable account 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.
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Balance Sheet Ratios Explained
The balance sheet ratios are also known as financial ratios that form an important part of financial statement analysis. Every institution prepares the balance sheet as part of their financial statements that are an important component of evaluation and analysis of the entity’s ability to meet its financial needs.
The various balance sheet ratios analysis as given in the article later on, are treated as valuable metrics that give the management and stakeholders important insight into the financial health of the business. They help to decide whether the company meets some important criterias like solvency, efficiency, liquidity, etc. It helps decide whether it is a profit-making entity. Investors can make important financial decision based on these ratios because it clarifies the future potential of the business.
A strong balance sheet is a factor to decide the creditworthiness of any organization. Banks and other financial institution extend loans to them on the basis of these balance sheet ratios formulas because it gives them an insight into the capacity of the business to pay off the debts on time and help the lenders avoid bad debts. However, these ratios should be used in conjunction with other important industry benchmarks to make financial and investment decisions.
The balance sheet ratios analysis 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 utilizes 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 the average inventory available with the company on the balance sheet date.
Inventory turnover = Cost of Goods Sold/ Average inventoryAverage InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business..
The inventory turnover ratio Inventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings. indicates how fast a company’s inventory is selling. In other words, they show how many times the company has sold its complete inventory and replenished it in a year. A low inventory turnover ratio is one of the key balance sheet ratios which 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.
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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. However, receivable turnover needs to be analyzed compared to the company’s peers 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, the cash and carry business will always have a less credit period than the manufacturing industry.
Payables Turnover Ratio
Payables Turnover Ratio is another one of the balance sheet ratios formulas and indicates how fast the company can pay 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 suppliers’ credit period extended to them. Similar to the account receivableAccount ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. turnover ratio, the Payables ratio also needs to be analyzed based on the industry the company operates in.
Asset Turnover Ratio
Another one of the key balance sheet ratios is the Asset Turnover Ratio which is calculated simply by dividing the sales by the company’s total assets. 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 company’s working capital has been effectively utilized to generate sales.
#2 – Liquidity Ratio
This type of Balance Sheet Ratio analysis is also known as the 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 one may indicate that the company is raising short-term funds from the market to create long-term assets, thus diverting funds.
The Quick RatioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities. 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 company’s current assets; however, at the time of distress, it might not be easily convertible to cash and hence cannot be used for instant debt payer 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., and hence cash ratio indicates 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 important balance sheet ratios, 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. In addition, 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.
DSCR = (Profit after taxProfit After TaxProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business. + Depreciation + Interest) / (Interest Payments Or Principal Payments + Lease Payments)
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 the firm’s assets 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 ratios are important balance sheet ratios measure the overall profitability of the business. The following are the types of Profitability Ratios.
Return on Asset
Return on assets measures the efficiency with which the company’s total assets can 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 what are Balance Sheet Ratio. We explain the concept along with its various types. You can learn more about accounting from the following articles –