How to Identify Financial Ratios from a Balance Sheet to Make Informed Decisions

Introduction

Financial ratios play an essential role in helping you, as an investor or business owner, to assess the financial health of an organization. As a business owner, knowing your financial ratios provide you with insights into how well your company is doing and whether you need to make any changes. As an investor, financial ratios can provide you with information on the sustainability of a company and help you decide if it would be wise to invest in them or not.

The purpose of this blog post is to provide an overview on how to identify and interpret financial ratios from a company's balance sheet. We'll look at the different types of financial ratios, how to calculate them, and how to use them to make informed decisions.


What is Balance Sheet?

A balance sheet is a financial statement which provides a snapshot of a company’s financial standing at a particular point in time. It is composed of two parts: the left-hand side, which is known as the “assets” side, and the right-hand side, which is known as “liabilities” and “equity.” It reflects the company’s financial strength, or lack thereof, based on the total value of its assets compared to its liabilities and equity.

Definition

The balance sheet is key information used by investors and lenders to analyze the financial health of a business. A balance sheet can show how a company is managing its resources, how it is funding its operations, and how much risk it is exposed to. In short, it is used to measure the company’s financial stability and soundness.

List of Balance Sheet Components

The balance sheet is categorized into three main components: assets, liabilities, and equity. Assets represent what the company owns, liabilities represent what the company owes, and equity represents the company’s ownership stake. The balances of each component are listed at the end of an accounting period, such as a month, quarter, or year.

  • Assets: Cash, Accounts receivable, Inventory, Prepaid expenses, Property, plant and equipment, Intangible assets, Investments
  • Liabilities: Accounts payable, Bank loans, Short-term loans, Debt securities, Derivatives, Accrued expenses
  • Equity: Common stock, Preferred stock, Retained earnings, Accumulated other comprehensive income


Types of Financial Ratios

In order to make informed decisions, financial ratios derived from a company's balance sheet can be used as valuable tools. There are a number of different types of financial ratios, each of which provide different insights into a company's overall performance.

Leverage Ratios

Leverage ratios measure the amount of debt a company carries in relation to their overall financial position. This type of ratio is useful in understanding the level of risk of an investment, as a company with a large amount of debt may be more vulnerable to changes in the economy, other businesses, or the markets.

Liquidity Ratios

Liquidity ratios measure a company's short-term ability to meet its financial obligations. This type of ratio is useful in assessing the overall financial health of a business. If a company has too little liquidity, it may be unable to pay its bills in a timely manner, or may be susceptible to negative financial impacts from unexpected events.

Asset Management Ratios

Asset management ratios measure how efficiently a company operates the assets at its disposal. These ratios indicate how well the company is utilizing its resources and whether it is capable of creating long-term value. This type of ratio is useful in determining the overall efficiency of the company and its prospects for further growth.

Profitability Ratios

Profitability ratios are designed to measure how successful a company is at generating profits. These ratios are useful in evaluating whether a business is producing a return on investment and whether it is likely to continue to be profitable in the future.

Market Value Ratios

Market value ratios measure how well a company is performing in comparison to its competitors or the overall market. This type of ratio is useful in assessing the potential return on an equity investment, as it provides an indication of the company's relative performance and future prospects.


How to Calculate Financial Ratios

Financial ratios are a reliable tool that helps investors and management to evaluate financial performance and position of an organization. Different financial ratios indicate different financial aspects, and investors and managers may use them to analyze the performance of their organization. Knowing how to calculate financial ratios from the company’s balance sheet and other financial statements is crucial for investors and management to make informed decisions.

Step-by-step Guide

To calculate financial ratio from the balance sheet and other financial statements, one should start by gathering all relevant financial documents from the organization, including the balance sheet, income statement, statement of cash flows, and statement of shareholders’ equity. Every financial statement can provide different perspectives that are essential for calculation of the financial ratios though a balance sheet and income statement are usually more important.

After gathering the documents, the following steps should be taken in order to calculate the financial ratios:

  • Step 1: Calculate the asset turnover ratio by dividing the sales revenue with average total assets.
  • Step 2: Calculate the debt-to-capital ratio by dividing the total liabilities with the sum of total liabilities and shareholder’s equity.
  • Step 3: Calculate the ROA (Return on Assets) by dividing the net income with total assets.
  • Step 4: Calculate the ROE (Return on Equity) by dividing the net income with the shareholder’s equity.
  • Step 5: Calculate the capital structure ratio by dividing the total liabilities with total equity.
  • Step 6: Calculate the working capital by subtracting the total current liabilities from total current assets.
  • Step 7: Calculate the dividend payout ratio by dividing the total dividends with the net income.

It is important to note that each ratio should be calculated according to the industry norms in terms of formula and period for which the ratio should be calculated for a valid comparison. Using the ratios, one can compare the performance of the organization with the industry, or can compare the same organization’s performance over different time periods. This will help the investors and management to determine the financial direction of the company, allowing them to make an informed decision.


Examples of Financial Ratios

When it comes to analyzing the financial performance of a firm, accountants and investors use various financial ratios to gain a better understanding of the company’s position. These common financial ratios taken from the balance sheet of a business allow stakeholders to make informed decisions regarding the future of the firm. Five common financial ratios are leverage, liquidity, asset management, profitably and market value.

Leverage

Leverage measures the degree to which a company is utilizing debt to finance its operations, more specifically, how much debt is held as compared to equity. It is an important indicator, as too much debt can lead to financial strain and potential bankruptcy. Leverage is calculated by subtracting total liabilities from total equity, and then dividing by total equity. A lower number is generally good, as it indicates the company has more assets than liabilities.

Liquidity

Liquidity gauges a company’s ability to pay off short-term liabilities. The higher the ratio, the better able a company is to meet its short-term obligations. Liquidity is calculated by dividing current assets by current liabilities. Generally, a ratio of greater than one is considered adequate.

Asset Management

Asset management measures how efficiently a company manages its assets. It is calculated by dividing sales by total assets. A higher number indicates that the company is utilizing its assets effectively.

Profitability

Profitability is the most popular of financial ratios, and it is used to measure the company’s performance in relation to its revenues and expenses. It is calculated by subtracting total expenses from total revenues and then dividing by total revenues. A higher ratio indicates a more profitable company.

Market Value

Market value shows the market capitalization of a company, or the total value of the company based on its share price. It is calculated by multiplying the current stock price by the total number of outstanding shares. A higher number indicates that the company is worth more in the eyes of the market, while a lower number usually means investors believe it is undervalued.


Benefits of Financial Ratios

Financial ratios provide numerous benefits to help businesses make informed decisions. By analyzing financial information, businesses can monitor their performance and better predict future outcomes.

Setting the right financial objectives

Financial ratios can help identify areas of improvement and highlight strengths and weaknesses in a business’s financial performance, allowing businesses to set effective objectives and make management decisions. Through goals such as maintaining a certain level of liquidity and increasing profit margins, businesses can measure their performance against the industry standard and adjust their objectives as needed.

Achieving Goals

Financial ratios can also help businesses measure progress against their stated goals and assess the success of past decisions. By comparing individual financial measurements to the industry standard or to past performance, businesses can quickly identify any discrepancies. This information can be used to create strategies, adjust objectives, and identify opportunities for improvement.

Identifying improvement opportunities

Financial ratios can help a business identify potential improvements and assess the results of new approaches. For example, if a business has identified a need to improve its liquidity, it can analyze the effectiveness of different strategies such as reducing debts or increasing the cash flow from operations. A comparison of the current financial ratios against the original objectives can help pinpoint areas that can be improved and point out the effectiveness of the strategies.


Conclusion

Financial ratios provide information that helps users assess the financial health of a business, providing a comprehensive view that can be readily accessed from a balance sheet. However, users must understand the different types of ratios, as well as the context in which they are calculated and interpreted, in order to make informed decisions.

Summary

This blog post discussed how to identify and interpret financial ratios from a balance sheet. We began by understanding the different financial ratios that are commonly used, such as liquidity ratios and profitability ratios. We then discussed how to interpret these ratios in the context of a business’s financial health. Finally, we reviewed the tips and tricks to understanding financial ratios so that users can make informed decisions.

The Value of Financial Ratios

Financial ratios provide an invaluable tool for investors and business owners alike to evaluate the financial health of a business. By understanding the different types of ratios, their context and methods for calculating them, users can make better decisions about the businesses they choose to invest in.

The ability to quickly identify the financial health of a business from a balance sheet allows users to make decisions more quickly, accurately, and confidently. This is especially true for investors looking to determine the “value” of an investment as a result of an increased understanding of underlying financial statements.

Excel Dashboard

ONLY $99
ULTIMATE EXCEL DASHBOARDS BUNDLE

    Immediate Download

    MAC & PC Compatible

    Free Email Support

Related aticles