How to analyze Balance Sheet with financial Ratios?

by Muhammad Ali

What is a balance sheet?

The balance sheet is a financial statement that shows what a company owns and owes, as well as how much its shareholders have invested. In short the statement reveals the company’s assets, liabilities, and owners’ equity. 

If you are a company’s shareholder or an investor, you should understand how balance sheets are created, how to read them, and the basics of analyzing them.

How the Balance Sheet Works

The balance sheet is divided into two parts based on the following equation, a company’s assets with its liabilities plus its shareholder equity.

Assets = Liabilities + Shareholders’ Equity

This means that the assets of a business, or the methods by which it operates, are balanced by its financial liabilities, as well as the equity investment made into it and its retained earnings.

  • Assets are what a company uses to operate its business, such as cash, inventory, or money the company is owed.
  • Liabilities are sources that support these assets, like salaries, rent, mortgages, and loans.
  • Equity: This is a company’s net worth. The initial investment in the company, plus any retained earnings, serves as a source of funding for the business.

Why balance sheets are important

The balance sheet is an important tool used by investors, analysts, and regulators to understand the current financial health of a business. The income statement and the cash flow statement are the two other forms of financial statements that are typically used along with it. 

Balance sheets provide a quick overview of the assets and liabilities of the company. The balance sheet can help users 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.

Analyzing a Balance Sheet with Ratios

Ratio analysis is a mathematical approach of getting insight into a company’s liquidity, operational efficiency, and profitability by the analysis of financial statements such as the balance sheet and income statement. 

We can review some techniques used to analyze the information contained within a balance sheet. The main technique is financial ratio analysis. External parties who set risk-related benchmarks may also need ratio analysis.

Debt-to-Equity Ratio

  • It compares a company’s total liabilities to its shareholder equity and can be used to determine how much it depends on debt. Investors use it to determine which might be a lower-risk investment.

  • A high debt-to-equity ratio means the company is borrowing more cash from the market to support its operations, while a low debt-to-equity ratio indicates that the company is making better use of its assets and borrowing less from the market. 

  • Formula: D/E = Total Liabilities / Total Shareholders’ Equity 

Liquidity Ratios

  • Liquidity ratios are a type of financial indicator used to determine the ability of a debtor to repay current debt obligations without offering additional money.

  • It determines the company’s ability to cover short-term obligations and cash flows.

  • Formula: Current Ratio = Current Assets / Current Liabilities.

Solvency Ratios

  • A solvency ratio examines a firm’s ability to meet its long-term debts and obligations.

  • Solvency ratios and liquidity ratios both measure a company’s financial health, but solvency ratios have a longer-term outlook than liquidity ratios.

  • Formula: Interest Coverage Ratio =  EBIT / Interest Expenses. 

Activity Ratios

  • It indicates how efficiently a company is leveraging the assets on its balance sheet to generate revenues and cash.
  • Activity ratios can be subdivided into merchandise inventory turnover ratios, total asset turnover ratios, return on equity measurements, and a spectrum of other metrics.
  • Formula: Days of Sales Outstanding = Number of Days in Period / Receivables Turnover

Example of a Balance Sheet

The image below is an example of a comparative balance sheet of Apple, Inc

balance sheet of Apple

Apple’s balance sheet clearly indicates that the company is well-managed. It provides its facts in an understandable form and has no significant exposure to off-balance-sheet issues that might hide its genuine condition.

Investors should be aware that a company’s balance sheet may deteriorate when its earnings situation and industry position fluctuate. Before buying, it is important to review the company’s most recent balance sheet.

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