Also note how the balance sheet is how it is arranged. The assets and liabilities are listed by how current the account is. Assets are ordered from most current to least current. Liabilities are ordered from short to long-term borrowings and other obligations.

 

 

Analyze the balance sheet with ratios

The main way one analyzes a balance sheet is by calculating a number of financial ratios.  For the balance sheet, using financial ratios (like the debt-to-equity ratio) can give you a better idea of how healthy and efficient the company is. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.
The main types of ratios calculated from the balance sheet are financial strength ratios and activity ratios.  Financial strength ratios measure the company’s ability to pay its debts, and also show how the obligations are leveraged. These are subdivided into liquidity ratios and debt (or leveraging) ratios. Liquidity ratios measure the availability of cash to pay debts. These include the following:

 

Liquidity ratios:
Current ratio (Working Capital Ratio):  Current assets / Current liabilities
Acid-test ratio (Quick ratio): [Current assets — (Inventories + Prepayments)] / Current liabilities
Cash ratio:  Cash and marketable securities / Current liabilities
Operation cash flow ratio:  Operating cash flow / Total debts

 

Debt ratios:
Debt ratios quantify the company’s ability to repay long-term debt and measure its financial leverage. These include

Debt ratios (leveraging ratios): 
Debt ratio:  Total liabilities / Total assets
Debt to equity ratio:  (Long-term debt + Value of leases) / Average shareholders’ equity
Long-term debt to equity (LT debt to equity):  Long-term debt / Total assets
Times interest earned ratio (Interest coverage ratio):  EBIT / Annual interest expense*
(*EBIT stands for Earnings before Interest and Taxes. EBIT and Annual interest expense are not found on the balance sheet, but on the income statement.)

 

Financial strength ratios give investors an idea of how financially stable the company is and how the company finances itself.  Activity ratios, by contrast, measure how efficiently the company uses its resources.  They focus on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables).

 

Activity ratios (Efficiency Ratios):

Average collection period:  Accounts receivable / (Annual credit sales ÷ 365 days)
Degree of operating leverage (DOL):  %Change in net operating income / %Change in sales
DSO ratio:  Accounts receivable / (Total annual sales ÷ 365 days)
Average payment period:  Accounts payable / (Annual credit purchases ÷ 365 days)
Asset turnover:  Net sales / Total assets
Stock turnover ratio:  Cost of goods sold / Average inventory
Receivables turnover ratio:  Net credit sales / Average net receivables
Inventory conversion ratio:  365 days / Inventory turnover
Inventory conversion period:  (Inventory / Cost of goods sold) x 365 days
Receivables conversion period:  (Receivables / Net sales) x 365 days
Payables conversion period:  (Accounts payable / Purchases) x 365 days
Cash conversion cycle:  (Inventory conversion period + Receivables conversion period – Payables conversion period)

 

Several of these also require information from the other financial statements.

---

10.2.3 The income statement