What is Balance Sheet Ratio Analysis?
Balance sheet ratios are the key indicators to analyze the balance sheet strength of the company. Thus, balance sheet ratios are quantitative tests of the financial condition of the company.
Comparisons are essentially intended to shed light on how well a company is achieving its objectives in comparison to its peers in the same industry. Thus, balance sheet ratios are used to assess the expected returns, a risk associated, financial stability, etc. However, these ratios vary across industries and hence comparisons between companies from completely different industries is not valid. Balance sheet ratios majorly include balance sheet items like assets, liability, shareholders equity, etc.
Types of Balance Sheet Ratio Analysis
Balance Sheet Ratio 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 is utilizing its assets. It indicates the overall operational performance of the company.
Various efficiency ratios are as follows:
Inventory Turnover Ratio
It is calculated by dividing the cost of goods sold by average inventory available with the company on the balance sheet date.
Inventory turnover ratio 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. Low inventory turnover ratio indicates lower sales or that the company is holding up stocks of goods which 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 period given to customers vary from industry to industry. For example, a 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 balance sheet date.
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It indicates as to 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 account receivable turnover ratio, 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
Net working Capital 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. Liquidity ratio is industry dependent and varies majorly from industry to industry.
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 doing diversion of funds.
Inventory is a major part of 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 pay or recovery.
Most conservative liquidity ratio is cash ratio. Cash is the most liquid asset on the 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 ratio 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 obligation.
Types of Solvency Ratio are as follows,
Debt to Equity Ratio
Debt to Equity Ratio is also called financial gearing. It indicates how much equity is available to cover debt obligations.
Debt Service Coverage Ratio (DSCR)
DSCR Ratio indicates the ability of a company to repay its debt obligations.
Debt to Asset Ratio
Debt to Asset is used to analyze what portion of assets of the firm are funded by debt. A high number indicates high financial leverage
#4 – Profitability Ratios
These balance sheet ratios measure of the overall profiability of the business. 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. High ratio value indicates efficient utilization of company’s assets.
Return on Equity
Return on Equity 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 formulas and classifications. You can learn more about accounting from the following articles –
- What is a Balance Sheet Reconciliation?
- Solvency Ratio Formula
- Current Liabilities Formula
- How to Read a Balance Sheet?
- (COGM) Cost of Goods Manufacture
- Working Capital Turnover Ratio
- List of All Financial Ratios (Formulas)
- Ratio Analysis in Excel
- Limitation of Ratio Analysis
- Advantages of Ratio Analysis