Formulas and Calculations for Analyzing a Balance Sheet
Simple Formulas for Analyzing Any Balance Sheet
As part of ongoing due diligence for your own business or an investment target, it's smart to perform different types of financial statement analysis. As part of the process, you'll want to include financial ratios because they're quick and easy to calculate and can provide you with a good amount of insight.
Use this page as a handy reference, as these ratios are priceless tools for your investment toolbox, to be used whenever you need to dig into the details of a company's balance sheet and find out what's really going on.
Formulas and Calculations for the Balance Sheet
The following balance sheet ratios and calculations are divided into one of two groups. The first covers those that demonstrate a company's financial strength and liquidity, while the second gives a glimpse into a company's efficiency in using its asset base to generate earnings.
While these ratios are used to analyze the balance sheet, many of them also require the use of information from the income statement in conjunction with the balance sheet.
Balance Sheet Calculation and Ratio Group I
The following ratios act as measures of a company's financial strength and liquidity. Liquidity ratios are a useful type of financial metric that you can use to evaluate a company's ability to pay off its current debt obligations without having to raise any external capital.
Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.
- Working Capital: Current Assets - Current Liabilities
- Working Capital per Dollar of Sales: Working Capital ÷ Total Sales
- Current Ratio: Current Assets ÷ Current Liabilities
- Quick / Acid Test / Current Ratio: Current Assets minus inventory (called "Quick Assets) ÷ Current Liabilities
- Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity
Balance Sheet Calculation and Ratio Group II
Another way to analyze companies is to look at how efficiently they use their assets to generate income and profits for the business. You can use efficiency ratios, which examine various aspects of the business, such as how long it takes to for the business to collect cash from its customers, or how much time it takes to convert raw-materials inventory into cash.
Efficiency ratios are insightful and important tools because improving a company's efficiency ratios usually produces improved profits.
Use the following ratios to test a company's Efficiency:
- Receivable Turnover: Net Credit Sales ÷ Average Net Receivables for the Period
- Average Age of Receivables: Numbers of days in period ÷ Receivable Turnover
- Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for the Period
- Number of Days for Inventory to Turn: Number of days in Period ÷ Inventory Turnover
 These numbers are found on the income statement, not the balance sheet.
How to Use Ratios
While each of these ratios can provide valuable business insight, they're only useful in comparison to something else. You must compare a company's ratios to it's own ratios from an earlier period, or to the performance ratios of its peers, competitors, or its industry group averages.
The interpretation of a ratio's results depends on what you're comparing it to. Additionally, take care that ratios are calculated consistently over different periods of time or between different companies. For example, it's important to use gross sales consistently in all ratios instead of choosing net sales some of the time.
Another essential balance sheet formula involves taking the net income from the income statement and comparing it to a firm's net tangible assets, especially over multi-year spans that include at least one or more recessions, so you can get an idea of the economic characteristics of the business.
This won't work in some specialty cases, such as investing in shares of the oil majors, because the earnings are tied to an underlying commodity or commodities, such as natural gas and crude oil, which tend to enter multi-decade bull and bear markets related to the underlying supply/demand/extraction/refining relationships in effect at the time.
Nevertheless, it can often be an effective way to look through to the underlying economic reality of an enterprise and spot the caliber of the engine churning out profits for owners.
Once you understand how drastically different the outcome can be between a good business and a great business, it will become one of your favorite metrics. You'll likely find yourself demanding ownership in only those businesses that produce copious amounts of free cash flow; capable of providing you with ever-growing dividends or expanding book value rather than requiring on-going, low-or-mediocre returning capital expenditures that never quite seem to pay off the way you expected or hoped.