Many companies have suffered financial losses, faced massive accounting errors and serious dents to their reputation because of lethargic balance sheet management. The importance of good balance sheet maintenance cannot be stressed enough, especially when crisp data is a must for all loaning entities.
Many who have read Rich Dad, Poor Dad have a basic understanding of what a balance sheet is, i.e. a balance between assets and liabilities. Running industries needs more complex high-quality information than that. The P&L (Profit and Loss) account by itself will serve no purpose without a balance sheet.
Ratios you need to know
There are critical ratios that need to be on every promoter’s mind, and reviewed periodically, when looking at balance sheets because just tracking revenue growth and margins won’t suffice in the long run.
Quick ratio: This ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company. The formula used to calculate it is: Quick Ratio = (Current Assets – Inventories) / Current Liabilities. It is also called the acid test ratio. An acid test is a quick test for instant results.
Current ratio: It calculates how much money in assets is likely to be converted to cash within one year in order to pay debts that are due during the same year. You can find the current ratio by dividing the total current assets by the total current liabilities. To calculate the ratio, analysts compare current assets to current liabilities. Current assets include cash, accounts receivable, inventory and other assets that are expected to be turned into cash in less than a year. Current liabilities include accounts, wages, taxes payable and the current portion of long-term debt.
Debt to equity ratio: This ratio comes in different variations like total, long term and short term debt/equity ratio. The objective of these financial ratios is to determine how a company has been financing its growth.
A high ratio means that the company has been growing due to debt. It is important to note that not all debt is bad but it can become a liability when you have to pay the excessive debt by taking loans and giving interest payments. An important factor to consider then is to determine whether the returns generated from the debt exceeds the cost of debt.
Interest coverage ratio: The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes by the company's interest expenses for the same period. It measures the margin of safety a company has for paying interest during a given period, which a company needs in order to survive unpredictable financial hardships in the unforeseeable future. The margin of safety is a peek into a company’s solvency and something shareholders are interested in when it comes to returns.
Cash-on-cash ratio: In investing, this is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. It is often used to evaluate the cash flow from income-producing assets. Cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property. It is considered relatively easy to understand and one of the most important real estate ROI calculations.
Working capital ratio: The difference between current assets and current liabilities yields a company's working capital. A positive or negative working capital metric depends upon the industry a company is from. Both are favourable metrics depending on the industry.
Like the above important metrics, there are other ratios like solvency, activity, liquidity, turnovers, capital structure ratios and more in a balance sheet to measure a company’s health.
Compare balance sheets with peers:
Any company should compare its balance sheets with its successful peers to understand if they're on the right path and what ratios they should be looking if they belong to production, services or industrial sectors.
The Return on Capital Employed (ROCE) measures a company's profitability and the efficiency with which its capital is employed. It differs for every company based on their financial needs, so choose which peers you want to compare your ROCE against.
Most banks and investors look at balance sheet and net worth to decide if a company has stable growth and is worth investing in. A balance sheet allows them to assess a company’s financial situation and its solvency.
A balance sheet reveals the underlying economic reality of a company and investigates if the whole operation is providing returns to stakeholders.
The thoughts and opinions shared here are of the author.
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