Definition of Balance Sheet Ratios
Balance sheet ratio analysis is one of the key milestones of the company’s fundamental analysis by using the information available in its financial statements, typically in the balance sheet, to set up the relationship between different components of a company’s financial position.
Balance sheet ratio analysis primarily aims to compare various line items of the balance sheet pertaining to a business. It is targeted to evaluate various metrics required to understand the performance of the company using aspects like components of assets, liabilities and shareholders equity. A balance sheet ratio will typically include two classes of assets or assets and liabilities or assets and shareholder’s equity or liability and shareholder’s equity.
Types of Balance Sheet Ratios
The different types of balance sheet ratios are as follows:
1. Solvency Ratios
The prime aim of this is to monitor whether the business has enough cash and assets to survive in operations and whether the level of debt is low so that it does not face any future financial hurdles.
The quick ratio measures whether the business has enough liquid assets to meet its short term obligations. The higher the ratio, the beneficial it is to the company.
This is a better version of a quick ratio and checks the company’s ability to pay back its concerned liabilities. If the ratio goes below 1, it flags a warning for the company about whether it will be able to repay its short term liabilities. Again some companies which operate in particular industries that require a high level of debt will possess a lower current ratio as this is normal for the industry to have.
2. Debt Equity Ratios
Debt equity ratios are also important because they indicate how well balanced the company’s debt vs equity relation has or, in simple words, whether the company has enough equity to cover up its debt.
This denotes the extent to which a company’s total liabilities are secured or covered by the shareholder’s equity. The debt/equity ratio’s basic aim is to check how the company is financing its growth. A high number of this ratio means the company is more leveraging on debt.
This denotes to what extent the total long term liabilities of a company are secured or covered by the shareholder’s equity.
This denotes to what extent the total short term liabilities of a company are secured or covered by the shareholder’s equity.
3. Activity Ratios
Activity ratios help us measure the company’s efficiency and how well it is functioning by taking a measure of the company’s ability to convert the assets present in the balance sheet into sales or cash.
It measures how quickly and efficiently a business is converting the receivables into cash. Thus the ratio also helps to measure the health and efficiency of the company. A low DSO is concluded to be a good number meaning a business takes less time to convert its receivables into cash.
This measures the number of days businesses will store their inventory before selling their final goods. This ratio is more industry-specific.
It represents how many days a business typically pays back its creditors. Thus it also shows how long the business can make use of the cash before ending up finally paying it back.
This is a complete cycle of operations of a company that measures the effectiveness of the management. The lower the number, the better it is for the company.
4. Turnover Ratios
These ratios are more concerned with the inventory and how the company is churning its sales in the process of collecting its credit sales and other activities.
This ratio indicates how well a company is doing its collection on the basis of the credit sales it has made.
This ratio depicts how effectively a company generates sales from its inventory.
This ratio shows how many days it is required to sell a piece of the industry.
This ratio shows how well the company is managing inventories. It depicts the amount of inventory the business is holding as compared to the number of sales made.
Benefits of Balance Sheet Ratios
The benefits of balance sheet ratios are as follows:
1. Helps in Evaluating Operational Efficiency
Few of the ratios are targeted to evaluate the firm’s degree of efficiency at how it is handling its assets and other resources. It is a must for a firm that assets and financial resources are well utilized, and unnecessary expense levels are kept to a bare minimum. To get an overall picture of the efficiency of assets, turnover ratios and efficiency ratios can play a major role.
2. Maintain Liquidity
The liquidity problem is the major issue that many firms face these days, and thus every firm should maintain a certain amount of liquidity to meet its urgent cash requirement. Specifically to main short term solvency issues, quick ratio and current ratio can play a major role.
3. Determine the Financial Health
Some ratios are handy to determine the overall financial health and performance of a company. This can be indicated by determining the overall long term solvency of the firm. This helps in judging whether there is too much pressure on the assets or if the firm is over-leveraged. Thus, to avoid future liquidation problem, the business has to quickly recognize this. Ratios that prove handy in such scenarios are leverage ratios and debt-equity ratios.
4. Helps in Comparing
Here, certain ratios are used to compare the benchmarks prevalent in the industry to get a better outlook of the company’s financial performance and position. The business can take rectifying actions if the company does not maintain the standard. Here generally, the ratios are compared to the previous year’s ratio to understand the company’s track record.
Limitations of Balance Sheet Ratio
The limitations of the balance sheet ratio are as follows:
- Use of Historical Data: All the information used in ratio analysis is based on historical numbers only. These data are drawn from historical actuals and by no means will remain the same in the future as business performance changes with every passing time.
- The Concept of Inflation: When we compare period-wise numbers for trend analysis, and if the inflationary rate has changed in between the periods, the comparison makes no sense. Ratio analysis does not account for the inflation factor at all.
- Opportunities for Window Dressing: Some firms may manipulate the numbers to bring about changes to the ratio for displaying a better picture of the firm. Thus in ratio analysis, there are scopes of window dressing.
- Variation of Rules to Value Assets: Different assets are valued according to different sets of rules practiced by different businesses. Thus a comparison of two companies during peer to peer analysis does not give a true picture.
- Time Effect: Some ratio pick numbers from the balance sheet, which is prepared only on the accounting period’s last day. Thus if there is any sudden shoot or decline in the number pertaining to the last day of the accounting period, it can drastically impact the overall ratio analysis.
The balance sheet ratio has both advantages and disadvantages of its own and solely depends on the analyst who is using this and what he/she is using this for. Even then, the advantages clearly outweigh the disadvantages as for people outside the company; this is the only way to get a better view of the company’s financial position.
This is a guide to Balance Sheet Ratios. Here we discuss the introduction and different types of balance sheet ratios along with benefits and limitations. You may also look at the following articles to learn more –
- Working Capital Turnover Ratio
- Return on Capital Employed
- Altman Z Score
- Quick Ratio
- Guide to Leverage Ratio for Banks