Formulas and Calculations for Analyzing a Balance Sheet
Simple Formulas for Analyzing Any Balance Sheet
Whether you're a beginning investor learning the ropes or a veteran business owner, it's smart to regularly review financial statements such as balance sheets. As part of that review process, you'll want to use financial ratios. These calculations quickly provide you with insight into a company's inner workings.
For those who are unfamiliar, these ratios and formulas are priceless tools to add to your investment toolbox. Knowing how and when to calculate them can help you parse through the details in a balance sheet and find out what's really going on with a company's financials. For those who already know the benefit of calculating financial ratios, use this page as a handy reference when you need a refresher.
Defining Balance Sheet Ratio Groups
For this piece, the balance sheet ratios and calculations are divided into two groups. The first group of calculations is used to assess a company's financial strength and liquidity. The second group of calculations gives investors a glimpse into a company's efficiency. In other words, the second group of ratios demonstrates how effectively a company uses its asset base to generate more earnings.
While these ratios are used to analyze the balance sheet, some of the calculations require information that's found on a company's income statement. When you work through these calculations for yourself, it's best to have both the income statement and the balance sheet at hand.
Measuring Financial Strength and Liquidity
The following ratios act as measures of a company's financial strength and liquidity. Liquidity measurements such as working capital and quick ratios help you evaluate a company's ability to pay off its current debt obligations without having to raise any external capital. This information helps investors determine a company's intrinsic value and margin of safety.
To assess how well a company could cover its short-term debt in cases of emergency, compare current liabilities to liquid assets.
Here are some key ratios and calculations used to determine financial strength:
- Working capital: Current assets - current liabilities
- Working capital per dollar of sales: Working capital ÷ total sales
- Current ratio: Current assets ÷ current liabilities
- Quick ratio (also called the acid test): (Current assets - inventory) ÷ current liabilities
- Debt-to-equity ratio: Total liabilities ÷ shareholders' equity
Measuring Company Efficiency
Another way to analyze companies is to look at how efficiently they use their assets to generate income and grow their profits. These efficiency ratios allow analysts to assess specific aspects of business operations, such as how much time it takes to convert inventory into cash. As a company improves its efficiency ratios, it often improves its profits, as well.
Use the following ratios to test a company's efficiency:
- Receivables turnover ratio: Net credit sales ÷ average accounts receivable
- Average age of receivables: Numbers of days in period ÷ receivable turnover
- Inventory turnover: Cost of goods sold ÷ average inventory
- Number of days for inventory to turn: Number of days in period ÷ inventory turnover
Use Formulas in Context
While each of these ratios can provide valuable business insight, they're only useful when assessed in a larger context. You must compare a company's ratios to its own ratios from an earlier period, or to the ratios of its peers, competitors, and industry averages.
As you're comparing your calculations, make sure that you're using consistent data. For example, if you're using gross sales to calculate one company's ratio, it's important to continue using gross sales for other companies, rather than using net sales some of the time. Similarly, you want to look at the same timeframe, so that broader economic events aren't impacting some data sets and not others.
If you're comparing two companies, it's also important to ensure that they're similar in nature. One company's inventory turnover might look great in one industry and awful in another. Inherent factors in some industries make them incomparable to other industries.
For example, consider the oil industry and the retail industry. The bull and bear markets in the oil industry may last for years, stretching much longer than the average industry's boom-and-bust cycle. The cycles of the retail sector, on the other hand, are much more rapid than the average industry—marked by a sharp spike in profits around the holiday shopping season every winter. Therefore, comparing the one-year financial snapshots of an oil company and a retail company won't provide much insight into which company is a better investment.
The Bottom Line
Once you understand how to calculate these financial metrics, use them to track and compare companies. You'll likely find that the companies with stronger ratios earn consistently better profits and perform better on the stock market. This can help you narrow your search for investment opportunities to those with copious amounts of free cash flow and the capability to provide you with ever-growing dividends.