How to Analyze a Balance Sheet
In a previous post, we introduced you to financial analysis by analyzing an Income Statement. In this post, we are going to take your financial analysis skills one-step further and learn how to analyze a Balance Sheet.
Analyzing a Balance Sheet is a bit more detailed than Income Statement financial analysis. When analyzing an Income Statement, you are often analyzing it in context of itself or prior historical trends. So for example, the percentage sales increase over two periods.
Balance Sheet analysis still involves trend comparison, but there is bit more math involved than just percentages. This doesn’t make Balance Sheet analysis more complicated, just a bit more detailed.
So with that in mind lets get started learning how to analyze a Balance Sheet.
Enter Ratio Analysis.
Ratio Analysis provides visibility into the Balance Sheet by comparing several components or accounts both on and off the Balance Sheet to each other.
What is a ratio? A ratio is simply the division of two metrics or measurements. So for example, one ratio could be the division of Debt to Equity. We would then just divide the Debt on our Balance Sheet divided by our Equity. This is known as our Debt to Equity ratio.
There are two main sets of financial ratios that we will cover that pertain directly to the Balance Sheet – Liquidity and Leverage ratios.
Liquidity ratios measure a company’s ability to meet its short-term obligations. An example would be a company’s ability to pay off short-term debt such as Accounts Payable or a short-term loan.
Below are a few of the standard Liquidity Ratios:
• Current Ratio = Current Assets/Current Liabilities
The goal is to have a Current Ratio higher than one, which would indicate that your Current Assets are higher than your Current Liabilities. This means that your business can service its short-term financial obligations.
• Quick Ratio = (Cash + Short-term Investments + Accounts Receivable)/Current Liabilities
The Quick Ratio is similar to the Current Ratio but excludes Inventory to give a true reflection of the company’s Current Asset balance.
It’s important to measure liquidity without the impact of inventory because the Inventory balance on the Balance Sheet may not reflect an accurate liquidation value for that inventory due to obsolesce etc.
A high inventory balance made of old or obsolete inventory can skew its value because it is not the true value that the market would pay for that inventory – a process called marking to market.
For example, an inventory balance consisting of last years model of product X is not as valuable to the market and hence not reflective of its true market value. Again you ideally would like to see a Quick Ratio above one.
• Cash Ratio = (Cash + Cash Equivalents)/Current Assets
The Cash Ratio is the most conservative measurement of a company’s liquidity because it solely focuses on the cash balances on the Balance Sheet. This ratio is conservative because it is truly the liquid value of the organization’s assets.
Liquid means that these assets can quickly and easily be converted into cash. The adage of “cash is king” is true when it comes to this financial ratio. As with the other Liquidity Ratios, a ratio higher than one is ideal.
Leverage Ratios highlight a company’s financing breakdown between debt and equity. Many organizations have a mix of both debt and equity and understanding the ratio of each is vital to determine the long-term financial viability of the business.
Below are a few of the standard Leverage Ratios:
• Debt Ratio = Total Debt/Total Assets
The Debt Ratio measures the company’s total leverage. Leverage means the total amount of debt the company has taken on in the form of loans.
The higher the Debt Ratio is, the more levered the company. This may not be a bad thing if the company has the ability to service this leverage or debt with high cash flows. So in other words, it has the ability to pay back the loan each month.
• Debt to Equity = Total Debt/Total Equity
The Debt to Equity ratio measures a company’s willingness or risk appetite for taking on debt as opposed to equity. A higher Debt to Equity ratio indicates that a company is more aggressive in taking on debt.
With a high Debt to Equity cash flow to service, the higher debt obligation is important. Having a Debt to Equity is not a problem in and of itself if the company is able to maintain viability while still servicing the high debt burden.
• Interest Coverage Ratio = Earnings before Interest & Taxes(EBIT)/Interest Expense
The Interest Coverage ratio measures a company’s ability to pay interest on their outstanding debt burden. The higher the ratio, the better – this means that the organization can pay the interest expense on their loan without disruption to the day-to-day viability of the business. This is an example of a business that is using debt to its advantage.
Those are just a few of the more common financial ratios that help us analyze a Balance Sheet. Ratio analysis and Balance Sheet financial analysis doesn’t have to be cumbersome and complex. But calculating each ratio correctly is imperative to paint a true financial picture of the small business.