Key Ratios to Analyse from Your Balance Sheet
A balance sheet is a fundamental financial statement that provides a snapshot of a business’s financial health at a specific point in time. For business owners and investors, analysing key ratios derived from the balance sheet is crucial for understanding a company’s financial position and making informed decisions. Here are some essential ratios that should be on your radar.
1. Current Ratio
The current ratio measures a company’s ability to pay its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities. A ratio above 1 indicates that the company has more assets than liabilities, suggesting good short-term financial health. This ratio is particularly useful for assessing liquidity and ensuring that the business can meet its obligations as they fall due.
2. Quick Ratio
Also known as the acid-test ratio, the quick ratio is a more stringent measure of liquidity than the current ratio. It excludes inventory from current assets, focusing on the most liquid assets, such as cash and receivables. This ratio is calculated by dividing the sum of cash, marketable securities, and receivables by current liabilities. A quick ratio of 1 or higher is generally considered satisfactory, indicating that the company can cover its short-term liabilities without relying on the sale of inventory.
3. Debt-to-Equity Ratio
This ratio measures the proportion of a company’s financing that comes from debt compared to equity. It is calculated by dividing total liabilities by shareholders’ equity. A high debt-to-equity ratio can indicate that a company is heavily reliant on debt to finance its operations, which can be risky, especially in volatile markets. Monitoring this ratio helps ensure that the business maintains a healthy balance between debt and equity financing.
4. Working Capital
Working capital is the difference between current assets and current liabilities. It indicates the short-term financial health of a company and its ability to cover its short-term obligations. Positive working capital means a company can fund its day-to-day operations and invest in future activities. Conversely, negative working capital might suggest potential liquidity problems.
5. Inventory Turnover Ratio
This ratio measures how efficiently a company manages its inventory. It is calculated by dividing the cost of goods sold by the average inventory. A high inventory turnover ratio indicates effective inventory management, as it suggests that inventory is being sold and replaced quickly. Conversely, a low ratio may indicate overstocking or obsolescence.
6. Receivables Turnover Ratio
The receivables turnover ratio indicates how effectively a company collects its outstanding credit sales. It is calculated by dividing net credit sales by average accounts receivable. A high ratio indicates efficient credit and collections processes, while a low ratio may suggest issues in collecting payments from customers.
7. Solvency Ratio
The solvency ratio measures a company’s ability to meet its long-term obligations. It is calculated by dividing net income plus depreciation by total liabilities. A higher solvency ratio indicates a greater ability to meet long-term debt obligations, which is a positive sign of financial health.
Understanding these key financial ratios is essential for anyone looking to gain insights into a company’s financial health. By regularly monitoring these metrics, business owners and investors can make informed decisions that drive growth and sustainability. It’s important to compare these ratios with industry benchmarks and consider the broader economic context when evaluating a company’s financial position. Engaging with a financial advisor or using resources like business.govt.nz can further enhance your financial analysis and ensure that you make well-informed decisions.