Balance sheet analysis and ratios

Another important technique used in financial analysis is ratio analysis. You have already been introduced to ratios previously.

Let’s re-examine ratios and their importance in the balance sheet.

Ratios express one quantity in relation to another. It’s a useful way of expressing relationships. There are a few aspects of ratios that you should recognise before using them for financial decision making.

• A computed ratio is not an answer.
• A ratio tells what has happened, not why it has happened.
• It does not provide an answer; instead it’s an indicator.

Ratios provide insights into:

• business relationships within a company that help analysts project earnings and free cash flow
• financial flexibility, or ability to obtain the cash required to grow and meet its obligations
• management’s ability to drive the business
• changes in the company and/or industry over time
• comparability with peer companies or the relevant industry.

Ratios have the following limitations:

• differences in industry make it difficult to compare the same ratio for companies across different industries
• need for consistency across time periods to facilitate comparison
• need to use judgement in interpreting ratios
• use of alternative accounting methods or shifts in accounting methods/treatment derails comparison of financial ratios.

There are different types of ratios that can be used by organisations.

We will discuss some of these ratios in greater detail in the next few topics. First, we will learn about balance sheet and ratio analysis and financial performance analysis.

Key categories of financial ratios associated with the balance sheet are:

• Liquidity ratios
• Solvency ratios

Key data points for the aforementioned ratios are drawn from the current period as well as prior period balance sheets. The key data points are derived from current and noncurrent assets, current and noncurrent liabilities, as well as equity. To analyse trends, ratios built on multi-period balance sheets should be used.

Common and critical ratios of balance sheet

Let’s review each of the different types of ratios.

Liquidity ratios

Liquidity analysis focuses on the company’s cash flows. It assesses the ability of the company to meet its short-term obligations. Liquidity is a depiction of how quickly assets can be converted into cash. It also provides guidance on how quickly the company can pay off short-term obligations.

Liquidity needed may differ from one industry to another. You can judge whether a company has adequate liquidity by assessing the following factors:

• historical funding requirements
• current liquidity position
• anticipated future funding needs
• options for reducing funding needs or attracting additional funds.

Commonly used liquidity ratios are as follows.

Let’s interpret and discuss each of these liquidity ratios.

Current ratio

Current ratio expresses the current assets in relation to the current liabilities.

• A high current ratio indicates high liquidity and the ability to meet short-term obligations.
• A current ratio of 1.0 indicates that the book value of its assets exactly equals the book value of its current liabilities.
• A lower ratio implies less liquidity and greater reliance on operating cash flow and outside financing to meet short-term obligations.

Quick ratio

More conservative than the current ratio, the quick ratio includes only the more liquid assets, known as quick assets. It compares quick assets relative to current liabilities.

• A higher quick ratio indicates greater liquidity.
• Indicates that inventory may not be easily converted into cash.
• When the inventory is illiquid, the quick ratio may be a better indicator of liquidity than the current ratio.

We will discuss the cash ratio, defensive interval ratio, and cash-conversion cycle along with cash flow statements.