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
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.
What is KPI in a balance sheet? ›
Your business's Key Performance Indicators (KPIs) are your tools for measuring and tracking progress in essential areas of company performance. Your KPIs provide you with a general picture of the overall health of your business.
What are the most important ratios in balance sheet? ›
Key Takeaways
Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE). Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company's financial health.
What indicates a good balance sheet? ›
What's considered a strong balance sheet?
- A positive net asset position.
- The right amount of key assets.
- More debtors than creditors.
- A fast-moving receivables ledger.
- A good debt-to-equity ratio.
- A strong current ratio.
- Trade Finance.
- Debtor Finance.
They call these metrics the Accelerate metrics, (also known as DORA metrics) and they include:
- Lead time for changes.
- Deployment frequency.
- Mean time to restore.
- Change failure rate.
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 are the 5 financial performance indicators? ›
The five primary types of performance indicators are profitability, leverage, valuation, liquidity and efficiency KPIs. Examples of profitability KPIs include gross and net margin and earnings per share (EPS). Efficiency KPIs include the payroll headcount ratio. Examples of liquidity KPIs are current and quick ratios.
What are the 5 KPIs? ›
KPIs can be financial, including net profit (or the bottom line, net income), revenues minus certain expenses, or the current ratio (liquidity and cash availability). Customer-focused KPIs generally center on per-customer efficiency, customer satisfaction, and customer retention.
What is a balance sheet indicator? ›
The balance sheet also indicates an organization's liquidity by communicating how much cash an organization has at present and what assets will soon be available in the form of cash.
What is the most important figure on 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.
The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity. As such, the balance sheet is divided into two sides (or sections). The left side of the balance sheet outlines all of a company's assets.
What are signs of a strong balance sheet? ›
Strong balance sheets will possess most of the following attributes: intelligent working capital, positive cash flow, a balanced capital structure, and income generating assets.
How to analyze the balance sheet? ›
The balance sheet is broken into two main areas. Assets are on the top or left, and below them or to the right are the company's liabilities and 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 a good balance sheet reconciliation? ›
Best practices in account reconciliation include thorough reviews to detect and rectify any timing differences or fraudulent activities, safeguarding the integrity of financial reporting and supporting the CFO and business owner in strategic decision-making.
What is the most important thing on 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 financial metric is the most important to a company? ›
A company's operating efficiency is key to its financial success. Operating margin is one of the best indicators of efficiency. This metric considers a company's basic operational profit margin after deducting the variable costs of producing and marketing the company's products or services.
What are the indicators on a balance sheet? ›
A strong balance sheet will typically show a high ratio of assets to liabilities and adequate liquidity, which is the ability to pay debts due in the short term. Other indicators include cash flow coverage ratios, debt-to-equity ratio, and accounts receivable turnover.
What are metrics in financial statements? ›
What are Financial Metrics? Financial metrics are used to evaluate and assess the financial performance, health, and stability of a company or an investment. These metrics are derived from a company's financial statements, such as the balance sheet, income statement, and cash flow statement.
