The ratios calculated from a company's balance sheet are used to determine its liquidity, solvency, and profitability. You can calculate three types of ratios from the balance sheet: liquidity (turn assets into cash); solvency (cash or equivalents to pay debts); and profitability.
There are tons of ratios that can be used. Here's how to calculate the most common ones for investors.
What Are the Balance Sheet Ratios?
The balance sheet is divided into three segments. Assets, or the value of what the company has, owns, or is owed. Liabilities (debts) are what the business owes. Shareholder's equity is the value that is owned by shareholders.
Balance sheets can have many types of entries. These signify where the money came from, where it went, and who owes it to the business. As an investor, you are likely most concerned with profitability (how much money a company makes; liquidity (how fast a company can pay its debts); and solvency (how a company can pay its long-term debts).
Not all companies report their finances the same on balance sheets. This makes it difficult to compare companies based on their financial information alone.
How Do You Calculate the Balance Sheet Ratios?
The balance sheet and the income sheet are used to determine many of the ratios used to analyze the balance sheet. For some of the ratios, you can use the information on just the balance sheet. For others, you need to use data from both sheets.
How Do You Calculate Profitability Ratios?
Profitability ratios show how much money a company makes. They also show how it distributes the cash to operate and reward investors.
- Gross profit
- Contribution margin
- Net profit
- Return on equity
- Return on assets
Gross profit margin is used to figure out how much profit is left after sales and when all administrative and selling costs have been paid. To calculate the gross profit of a company, use the formula:
The contribution margin ratio subtracts all variable expenses from sales and is divided by sales. The ratio demonstrates the percentage of profit left to pay for fixed expenses and call a profit. The formula reads:
The net profit margin ratio indicates the ratio of sales that is left after expenses are paid.
The return on equity ratio shows the ratio of income to shareholder's equity. This demonstrates your investment return.
A business's assets should provide profit for the company. The return on assets ratio offers a measurement of how well the business is doing this.
How Do You Calculate Liquidity?
Liquidity ratios measure how quickly a firm can pay off its debts by liquidizing assets or using cash. These ratios are:
- Current ratio
- Quick ratio
- Cash ratio
The current ratio measures the percentage of current assets to current liabilities. The one limitation of the current ratio is that it includes inventory; this isn't quickly turned into cash.
The quick ratio is the same as the current ratio. But you subtract inventory first; that's because it isn't a liquid asset.
Cash and convertible investments are compared to current liabilities; this shows how fast debts can be paid with either or both.
How Do You Calculate Solvency?
Solvency ratios are used to figure out how a company is positioned to pay off its debts. The current and quick ratios are capable of being used for liquidity and solvency tests.
- Current ratio
- Quick ratio
- Debt to equity
- Interest coverage
- Essential solvency ratio
The debt-to-equity ratio shows how much debt a company has compared to its equity.
The interest coverage ratio is used to figure out if a company can pay its interest debts.
One last ratio is not necessarily named but is essential to know. This ratio compares profit and non-cash items to all liabilities. It gives an investor a clearer picture of whether a business can meet all its financial obligations. This ratio is called the essential ratio.
How the Balance Sheet Ratios Work
The ratios are used to create the big picture of how a company manages its money. The profitability ratios, when used together, help figure out whether the business is creating earnings. There is one caveat to determining whether a business is profitable or not: It has to be compared to similar companies. They should be alike in financial structure, operational structure, supply chain, and other aspects of the business.
This comparison also needs to be applied to solvency and liquidity ratios, especially ratios that indicate low performance. All of these ratios have a general guideline that indicates whether the business is performing well or not. For instance, if you have $1 of debt and $3 of equity, your debt-to-equity ratio is .333. General guidelines for this ratio suggest that any ratio of less than one is a good indicator.
When judging whether a business is a good investment or not, it helps to compare as much past performance data as possible.
The ratios are beneficial for comparing a company's past to its current performance. This is often done on a comparative balance sheet that shows multiple periods' worth of data.
Limitations of the Balance Sheet Ratios
The ratios derived from a balance sheet can provide you with a picture of a company's finances. But the ratios are limited to a specific period. The snapshot you get is how the company has performed in the past; it's not how it performs in the present.
Publicized balance sheets often don't advertise much of the financial knowledge that could be useful to you as an investor, such as the amount spent on specific projects. Instead, you may see an estimate of research and development costs. This can be useful, as it lets you know the company is reinvesting in itself. But not much else is helpful about it.
- Balance sheet ratios evaluate a company's financial performance.
- There are three types of ratios derived from the balance sheet: liquidity, solvency, and profitability.
- Liquidity ratios show the ability to turn assets into cash quickly.
- Solvency ratios show the ability to pay off debts.
- Profitability ratios show the ability to generate income.