Analyze these seven metrics on the balance sheet to check your company’s financial health.
The balance sheet your bookkeeper or accountant prepares is often forgotten among everyday business challenges, only to be remembered during the tax season.
If you’re an investor analyzing a company’s potential to reap returns or a business owner (or manager) looking to get your company’s financials back on track, you should know how to read a balance sheet.
The information on a balance sheet is critical to understanding whether your business is performing well on revenue. A balance sheet reveals how easily your company can repay old debt or take on more credit.
In this article, we explain seven key metrics you should read on your balance sheet to derive meaningful conclusions. (Not as technical as it may sound!) Before we do that, let’s do a quick recap.
What is a balance sheet?
A balance sheet is a snapshot of your company’s financials at a given point in time. On a balance sheet, assets (what you own) are presented on the left side, and liabilities (what you owe) plus equity are on the right side. This format of the balance sheet is structured around the following accounting equation:
Assets = Liabilities + Shareholders equity
At any time, the two sides must always be equal.
Why are balance sheet metrics important?
Having a vague understanding of your financial progress isn’t helpful. Balance sheet metrics provide definitive results that you can measure to determine where you should invest your efforts going forward—say to better manage your inventory or collect payments on time.
Balance sheet metrics offer insights into your business’s financial health across three broad attributes: short-term liquidity position, asset performance, and capital structure.
- Evaluate the short-term liquidity position. It includes measuring your business’s ability to maintain resources to meet urgent cash needs (e.g., paying employees, supporting production, paying the interest due on loans).
- Measure asset performance. It comprises assessing your company’s ability to use its asset resources, such as plants and machinery, to generate income and profit.
- Assess the capitalization structure. It means evaluating what combination of debt (i.e., loans from banks or investors) and equity (i.e., investment by shareholders) your company uses to finance operations and growth.
Working capital is how much money your business has to run day-to-day operations such as purchasing inventory and paying monthly interest on loans.
Negative or low working capital indicates that you may run into a cash crunch due to low funds. Contrastingly, too high working capital could indicate that you aren’t spending enough and are unnecessarily blocking funds in current assets—i.e., assets that can be converted into cash within a year—which could be invested for business growth.
Lenders and investors look for a balanced working capital to see if your company can stay afloat and support business operations while easily paying off new debt.
Working capital, also known as net working capital or net current assets, is calculated by subtracting current liabilities from current assets on the balance sheet.
Current liabilities include expenses that need to be paid within a year (e.g., the money you owe to suppliers or taxes you owe to the government), whereas current assets are the resources you own that can be converted into cash within a year (e.g., inventory or the money customers owe to you).
Let’s take an example. If a company’s balance sheet has $100,000 in total current assets and $60,000 in total current liability, then the working capital would be $100,000 – $60,000 = $40,000.
So, the company has $40,000 in working capital to pay rent, employees’ salaries, and loans due in the next year, among other short-term obligations.
Current ratio measures your company’s ability to pay off short-term obligations (i.e., expenses due within the next 12 months) using short-term assets (i.e., resources that can be converted to cash within the next 12 months).
Current ratio indicates whether your company needs additional liquidity or funds to run day-to-day operations.
Current ratio is calculated by dividing current assets by current liabilities on the balance sheet.
A value between 1.5 and 2 is considered ideal for current ratio; anything below 1 could be a cause of concern about your company’s ability to repay short-term loans. That said, the value can differ depending on your industry of operation.
If your business requires a high level of debt to run operations (and that’s standard for industries such as financial services and utilities), then it’s normal to have current ratio lower than 1.
Let’s take an example. If a company’s balance sheet has total current assets worth $100,000 and total current liabilities worth $60,000, then current ratio would be $100,000 / $60,000 = 1.66.
Current ratio of 1.66 indicates the company’s solid financial health to pay off short-term liabilities (e.g., rent, salaries) and take on more loans (if needed) with ease.
Quick ratio, compared to current ratio, is a more conservative indicator of your company’s ability to pay off short-term obligations. That’s because quick ratio considers only the “most” liquid assets. Therefore, it eliminates inventory from current assets, as it assumes that inventory (although an asset) can’t be turned into cash quickly.
As a business, you can eliminate other “not-so-liquid” assets, besides inventory, based on how you define quick assets—say, assets that can be converted into cash within 90 days.
More importantly, the accuracy of this ratio highly depends on how quickly your customers pay for the goods (or services) provided to them and on other financing arrangements with your debtors. Since quick ratio determines your company’s immediate financial health, it’s also called acid test ratio.
Quick ratio is calculated by subtracting inventory from current assets and then dividing the result by current liabilities.
The higher the ratio, the better your company’s immediate liquidity position. Quick ratio of 1 is considered normal and shows your company is well-equipped to pay off near-term obligations.
Let’s take an example. If a company’s balance sheet reports total current assets worth $100,000, total current inventory worth $10,000, and total current liabilities of $60,000, then the quick ratio would be ($100,000 – $10,000) / $60,000 = 1.5.
The company’s quick ratio of 1.5 indicates a good immediate liquidity position to pay off near-term debts and maintain business operations.
Cash conversion cycle (CCC) is a key indicator of your business’s ability to manage the two most important assets: accounts receivable (what customers owe you) and inventory.
CCC shows how well your business is at collecting payments due from customers and selling your inventory. CCC is measured in days. A low CCC value indicates that you’re able to receive payments on unpaid invoices and sell your inventory in a decent amount of time. Conversely, a high number indicates that you’re slow on collecting dues and could soon run into a cash shortfall.
Three components are used to calculate CCC: days sales outstanding, days payable outstanding, and days inventory outstanding.
Days inventory outstanding (DIO) is the average number of days your inventory sits idle. It’s calculated by dividing average inventory by cost of goods sold, and multiplying the result by 365 days.
Days sales outstanding (DSO) is the average number of days you take to collect payment from customers after a sale. It’s calculated by dividing average accounts receivable by total revenue received, and multiplying the result by 365 days.
Days payable outstanding (DPO) is the average number of days you take to pay back due bills. It’s calculated by dividing your average accounts payable by cost of goods sold, and multiplying the result by 365 days.
Cash conversion cycle is calculated by adding days sales outstanding and days inventory outstanding, and subtracting days payables outstanding from the result.
*To find out total revenue and cost of goods sold, refer to the income statement, also called the profit and loss statement, which is one of the four basic financial statements.
Let’s take an example. A company’s balance sheet reports $1,000 in inventory, $1,000 in accounts payable, and $5,000 in accounts receivable at the beginning of a fiscal year, and $3,000 in inventory, $2,000 in accounts payable, and $6,000 in accounts receivable by the end of the fiscal year. Cost of goods sold and total revenue, according to the income statement released at year-end, are $40,000 and $120,000, respectively.
For this company, CCC would be:
DIO = [($1,000 + $3,000)/2] / $40,000 x 365 = 18.3 days
DSO = [($5,000 + $6,000)/2] / $120,000 x 365 = 16.7 days
DPO = [($1,000 + $2,000)/2] / $40,000 x 365 = 13.7 days
CCC = 18.3 + 16.7 – 13.7 = 21.3 days
This means the company takes an average of 21.3 days to collect payments from customers and sell its inventory.
Return on assets measures management’s ability to generate value (or profits) for shareholders and business owners.
A company works with several assets, such as cash, machinery, and plants. Return on assets determines how effective managers are in reaping profits using company assets. It’s a key indicator of the business’s overall net worth.
Depending on the industry, companies can have markedly different ideal returns based on the cost of operations and other norms. For instance, a tech company’s ability to make profits through its assets won’t necessarily be the same as that of a food and beverage company.
Return on assets is calculated by dividing net income by average total assets. Net income can be taken from the income (or profit and loss) statement.
Let’s take an example. If a company’s balance sheet shows total assets worth $500,000 and its income statement shows profits worth $50,000, then return on assets would be $50,000 / $500,000 = 0.1 or 10%
This means the company generates 10% returns by utilizing $500,000 worth of assets.
Debt-to-asset ratio measures how much of your company’s performance (asset generation) is financed through loans and debts. Creditors and banks use this ratio to determine how your business is performing and if it’s risky to give your business a loan. Therefore, it’s also called debt ratio.
If the ratio is high, it means your asset generation is majorly funded through debt. In that case, lenders may charge you higher interest on new loans. Conversely, a low debt-to-asset ratio could help you secure low-interest loans by establishing your credibility in debt management.
Debt-to-asset ratio is calculated by dividing total liabilities (as they involve debt components) by total assets on the balance sheet.
A high debt-to-asset ratio means a company is growing mostly by taking on debt and perhaps not so much by making money through asset building.
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. It also means that the remaining 40% is financed through equity.
Debt-to-equity ratio indicates how much of your company’s operations are financed through debt versus equity. Equity involves investment by company shareholders, and debt involves liabilities taken in form of loans and credit.
It’s another key indicator of your company’s capital structure and tells whether your business is more dependent on loans or shareholders’ funds.
Debt-to-equity ratio is calculated by dividing total liabilities by total equity reported on the balance sheet.
A ratio of lower than 1 is considered good, as it indicates your company is generating funds to finance operations via equity rather than taking on debt. But if the ratio is higher than 1, it means lenders might find it risky to lend to your company, thereby hindering your ability to borrow in times of emergency or economic downturns.
Let’s take an example. If a company’s balance sheet shows total liabilities of $500,000 and total shareholder equity of $300,000, then its debt-to-equity ratio will be $500,000 / $300,000 = 1.66
Debt-to-equity ratio of 1.66 indicates that the company is using a large amount of debt money, as opposed to shareholders’ money, to run business operations. Since it’s already so leveraged and under debt, lenders would consider it highly risky to lend to this company.