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 1.5 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) ÷ 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, though a debt-to-equity ratio of zero may not be desirable, as it may indicate an inefficient capital structure.
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 questions can a balance sheet help answer? ›
The balance sheet can help users answer questions such as whether the company has a positive net worth, whether it has enough cash and short-term assets to cover its obligations, and whether the company is highly indebted relative to its peers.
How would you find a balance sheet useful? ›
A balance sheet is one of several major financial statements you can use to track spending and earnings. Also called a statement of financial position, a balance sheet shows what your company owns and what it owes through the date listed, as Accounting Coach stated.
What are good balance sheet ratios? ›
Your current ratio should ideally be above 1:1.
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Current Assets – Current Inventory) / Current Liabilities.
- Working Capital = Current Assets – Current Liabilities.
- Debt-to-equity Ratio = Total Liabilities / Total Shareholder Equity.
The balance sheet may look like just a bunch of numbers, but there are important relationships among them, referred to as “key performance indicators” (KPIs), derived from specific elements of the balance sheet, that are industry-standard, and essential to monitoring the overall financial condition of the firm.
How to measure a strong balance sheet? ›
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.
How to read a balance sheet for dummies? ›
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 balance sheet answer key? ›
A balance sheet is a financial statement that contains details of a company's assets or liabilities at a specific point in time. It is one of the three core financial statements (income statement and cash flow statement being the other two) used for evaluating the performance of a business.
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 does a good balance sheet look like? ›
A balance sheet should show you all the assets acquired since the company was born, as well as all the liabilities. It is based on a double-entry accounting system, which ensures that equals the sum of liabilities and equity. In a healthy company, assets will be larger than liabilities, and you will have equity.
The features of a balance sheet are as follows: A balance sheet consists of all the liabilities and assets of a company. It shows their value and nature enabling you to know the position of the capital on a specific date. However, it does not show any revenues or expenses.
How to solve balance sheet? ›
Assets = Liabilities + Owner's Equity. This is the basic equation that determines whether your balance sheet is actually ”balanced” after you record all of your assets, liabilities and equity. If the sum of the figures on both sides of the equal sign are the same, your sheet is balanced.
How to calculate balance sheet metrics? ›
Let's take an example. If a company's balance sheet shows total assets of $100,000 and total liabilities of $60,000, then its debt-to-asset ratio would be $60,000 / $100,000 = 0.6 or 60%. This means 60% of the company's asset generation and growth is financed through debt from creditors.
What is the 5% balance sheet rule? ›
State separately, in the balance sheet or in a note thereto, any item in excess of 5 percent of total current liabilities. Such items may include, but are not limited to, accrued payrolls, accrued interest, taxes, indicating the current portion of deferred income taxes, and the current portion of long-term debt.
What is a perfect balance sheet? ›
A healthy balance sheet is about much more than a statement of your assets and liabilities: it's a marker of strength and efficiency. It highlights a business that has the optimal mix of assets, liabilities and equity, and is using its resources to fuel growth.
What are the key elements of balance sheet? ›
A balance sheet typically includes the following items: assets (current assets and non-current assets), liabilities (current liabilities and non-current liabilities), and equity (common stock and retained earnings).
What are balanced metrics? ›
A balanced scorecard is a strategic management performance metric that helps companies identify and improve their internal operations to help their external outcomes. It measures past performance data and provides organizations with feedback on how to make better decisions in the future.
What are the keys to 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 two key indicators does the balance sheet provide? ›
A balance sheet provides an overview of your company's financial situation at a particular point in time. The left side of a balance sheet shows assets (what you own) while the right side shows liabilities plus equity. At any time, the two sides must always be equal.
