If you're dealing with balance sheet analysis and you don't know where to start, you're in the right place. In this article, you will learn how to analyze a balance sheet with 10 balance sheet ratios that will allow you to assess the financial health of a company.
Before we start, let me say that this article is not meant to be a simple list of balance sheet ratios that you could find anywhere else online. Here at Finbox, we make things differently. Our mission is to help you take your investments to the next level.
In this balance sheet analysis tutorial, you will discover not only how to calculate a series of balance sheet ratios, but you will learn why they are important, how they affect your investment returns, and how you can use them to optimize your portfolio.
Balance Sheet Analysis Goals
Before studying how to analyze a balance sheet, you must have a clear idea of what your goals are. In this case, it will help to keep in mind that an appropriate balance sheet analysis must allow you to answer these questions:
- Does the company have the necessary liquidity to pay its current debts? (Liquidity Ratios)
- Can the company pay its long-term debts with ease? (Solvency Ratios)
- Is the company using its assets efficiently? (Efficiency Ratios)
Now that we have established what the objectives of a balance sheet analysis are, let's dig deeper to find out which balance sheet ratios will help you meet them.
Balance Sheet Ratios: Liquidity Analysis
If the company's liquidity is not good enough, it could face severe difficulties in paying its current debts if its daily income stops (as in the case of a pandemic). The consequences would be even more severe in the event of a credit crunch (i.e., a sudden reduction in the general availability of loans.)
The following balance sheet ratios will help you assess if a company's liquidity position is good enough.
1) Current Ratio
Current Ratio = Current Assets / Current Liabilities
The current ratio is probably the most used liquidity ratio. It is used by investors and analysts to assess whether the company has enough current assets to pay off its short-term debt. A ratio below 1 is a warning sign because it could indicate that the company is facing financial difficulties. However, this varies from sector to sector, and the only way to know if the company is in the safe zone is to compare it to the other companies in the sector.
The easiest way to do that is to use the Finbox data explorer. Just follow these simple steps:
Sign Up for free at Finbox
Go to the Finbox data explorer
Select the company and the metric you want to check (In this case we want to check the current ratio.)
- Scroll down to Sector Benchmark Analysis
- Control in what percentile is your stock (If your company is lower than the 20% percentile, it is a warning sign that could indicate it is facing financial difficulties. As you can guess, it's all right for Apple.)
2) Quick Ratio
Quick Ratio = (Current Assets - Inventories) / Current Liabilities
The quick ratio is more conservative than the current ratio. It is preferable for all the industries with a high DIO (days inventory outstanding.)
The DIO is a metric that indicates how rapidly a firm sells the inventory it has in stock. For all the industries with a high DIO, it's better to exclude inventories from the calculation because they are not necessarily easily convertible into cash.
You can find out if your company has an adequate quick ratio by comparing it to other companies in the industry with the same process used previously.
3) Defensive Internal Ratio
Defensive Internal Ratio = Current Assets / Daily Cash Expenditures = Current Assets / (EBIT/365)
The Defensive Internal Ratio (DIR) indicates how many days the company can pay its daily cash expenses without other funding than its current assets. This is one of the best balance sheet ratios for liquidity analysis because it provides the analyst with the exact number of days the firm can operate without seeking external funding.
Okay, now you know how to analyze a balance sheet to check if a company has enough liquidity. Let's move on to the solvency analysis.
Balance Sheet Ratios: Solvency Analysis
Solvency analysis helps you evaluate the ability of a company to pay its long-term debt and the interest on that debt. A financially strong company has enough liquidity to pay its short-term obligations and, at the same time, must manage its capital structure appropriately. Let's find out how to analyze a balance sheet with solvency ratios.
4) Equity Multiplier
Equity Multiplier = Total Assets / Equity
The equity multiplier is a financial leverage ratio that measures the portion of assets that are financed by equity. An equity multiplier ratio that is too high compared to other companies in the industry may indicate that management is too aggressive in running the business.
However, you'll be surprised to learn that, according to James O'Shaughnessy's research, high financial leverage doesn't necessarily mean that the stock will perform poorly. In his studies, he considers the entire U.S. stock market and divides the stocks into 10 deciles according to their financial leverage. Shares in the lowest decile (those with the lowest financial leverage) performed much worse than those in the highest decile (those with the highest financial leverage). It seems that the market punishes stocks that are managed too conservatively because low financial leverage can lead to low returns.
What's more, the equity multiplier alone can't tell you much about the business. A company with high financial leverage may be safer than a company with a lower one if it generates much more cash flow to cover that debt.
Not surprisingly, the same research demonstrates that companies with low cash flow to total debt drastically underperform the market. In the 45-year backtest period between 1964 and 2009, stocks in the lowest decile for cash flow to total debt generated a 2.41% CAGR compared to the 11.22% CAGR of the overall market. If you don't want to underperform the market, you should definitely check in which decile your stocks are. You can check that with the Finbox data explorer (with the same process we used for the current ratio).
5) Long Term Debt To Equity
Long Term Debt To Equity: LT Debt / Shareholders Equity
This is another financial leverage ratio that tells you how the company is financing its growth. The same considerations made above also apply to this ratio. High debt doesn't necessarily mean bad performance. You must consider all the other factors related to debt: What sector does the company operate in? Does the company generate enough cash flow to cover that debt? What is the company using that debt for?
As of May 04, 2020, the sectors with the highest debt to equity ratio are Utilities, Real Estate, and Consumer Discretionary.
You can get stats and graphs like this directly in Excel with the Finbox Excel Add-in
Balance Sheet Analysis: Efficiency Ratios
Efficiency ratios help you evaluate how well a company manages its assets. These balance sheet metrics are really important because they can make the difference between a stock that underperforms the market and one that outperforms it.
6) Asset Turnover Ratio
Asset Turnover = Revenue/Average Total Assets
Asset turnover is used by investors to determine the value of a business's revenue relative to its assets. This ratio is typically used to measure how efficiently a company is using its assets to generate revenue. A higher asset turnover ratio indicates a more efficient business that is generating more revenue for every dollar of assets.
According to research carried out by James O'Shaughnessy, in the 45-year backtest period between 1964 and 2009, stocks in the lowest decile for Asset Turnover generated a 7.64% CAGR compared to the 11.22% CAGR of the overall market. At the same time, stocks in the highest decile (those with a high Asset Turnover ratio) generated a 13% CAGR, beating the market. You can find the top 100 stocks with the highest asset turnover ratio using this stock screener.
Source: Author's graph based on James O.Shaughnessy's Research
7) Days Inventory Outstanding
Days Inventory Outstanding = 365*(Average Inventory / COGS)
Days Inventory Outstanding (DIO), also known as days sales of inventory (DSI), measures the average number of days that a company takes to turn its inventory in sales. It tells you how well a company manages its inventory.
8) Days Sales Outstanding
Days Sales Oustanding = 365*(Average Account Receivables / Credit Sales)
Days sales outstanding (DSO) is the average number of days it takes for a company to collect cash from sales made on credit.
How many times do you hear the expression "Cash Is King"? Well, this is exactly the case. Since a company cannot use the credit it holds to pay its expenses and invest in the business, it must collect the cash as quickly as possible.
9) Days Payables Outstanding
Days Payables Oustanding = 365*(Account Payables / COGS)
Days payables outstanding (DPO) measures the average number of days it takes for a company to pay its suppliers.
In this case, it is the opposite of what we said above. A higher ratio gives the company much more flexibility in managing the business. At the same time, a too high ratio could be a warning sign that the company has some difficulties in paying its suppliers. The DPO is good if it is in line with the sector average. You can check that easily with the Finbox data explorer.
10) Cash Conversion Cycle
Cash Conversion Cycle: DIO+DSO-DPO
Although it may seem a bit difficult at first, the cash conversion cycle is a very simple concept. It simply tells you how much time passes between the time the company uses cash to pay suppliers, and the time it receives cash from its customers.
A lower cash conversion cycle is better since it means the company is collecting cash quickly from its customers and, at the same time, has more flexibility in paying its suppliers.
Finbox is here for you
I hope this article came in handy. And remember: as I told you before, here at Finbox, our mission is to take your investment to the next level. So, if you have any doubts, don't hesitate to ask. To contact us, sign up for free, and leave a message in the chat. We usually respond within 24 hours.
And don't forget to check in which decile your stocks are. You don't want to underperform the market, do you? Access now to the Finbox Data Explorer.
In this article, you learned how to analyze a balance sheet with the appropriate balance sheet ratios. If you found it interesting, you may also like this one in which we talk about a simple investing strategy that beats the market by generating a 17.9% compounded annual return between 1973 and 2017.