20 Critical Balance Sheet Ratios Investors Must Analyze
There’s only one reason why I continue to hold the majority of my portfolio in US stocks: the reporting and transparency requirements by the SEC rock.
Without them, calculating the below balance sheet ratios would be a nightmare.
The following list of ratios can be applied to both the public and private sectors. At Old School Value, we apply these ratios to help discover undervalued stocks to invest in. It makes a big impact by helping you avoid falling knives and value traps.
So, let’s get straight into the 20 balance sheet ratios you need to help you determine the financial health of a company. You will note that most of these balance sheet ratios are basic, which makes them easy to calculate. Simple ratios and ideas are often the best.
At the end of the article, you can download a pdf of the 20 balance sheet formulas and metrics.
Now, let’s get started on the balance sheet ratios refresher.
Solvency Ratios
Solvency Ratios are quick & easy to calculate and easy to interpret.
The objective is to see whether a company has enough cash, assets, and low debt to continue operations without running into financial trouble.
Quick Ratio
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick 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.
Current Ratio
Current Ratio = Current Assets / Current Liabilities
An even simpler variant to the quick ratio that is used to determine the company’s ability to pay back its short-term liabilities. You’ll see this balance sheet ratio everywhere.
If the ratio is below 1, it raises a warning sign as to whether the company is able to pay its short-term obligations when due. It doesn’t mean the company will go bankrupt but is something that has to be looked at. If a company has a low current ratio year after year, it could be a characteristic of the industry where companies operate and high debt levels.
Debt/Equity Ratios
Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity
Long Term Debt/Equity Ratio = Long Term Debt / Shareholders Equity
Short Term Debt/Equity Ratio = Short Term Debt / Shareholders Equity
There are different variations of the debt to equity ratios, but 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, or leverage. Not all debt is bad, but if the number is exceedingly high, remember that the company has to pay off the loan as well as interest payments.
An important factor to consider then is to determine whether the returns generated from the debt exceed the cost of debt (i.e., interest).
Activity Ratios
Activity financial ratios measure how well a company is able to convert its assets in the balance sheet into cash or sales. By analyzing the activity ratios, you can see how efficient and well run a company is.
These balance sheet metrics aren’t just for the company, but also measure the people behind the business and how well they are running the show.
Days Sales Outstanding (DSO)
Days Sales Outstanding = (Receivables / Revenue) x 365
Cash is king and a business capable of converting its receivables into cash quickly is a great sign of health and efficiency.
A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.
Days Inventory Outstanding (DIO)
Days Inventory Outstanding = (Inventory / COGS) x 365
This financial ratio is used to measure the average number of days a company holds inventory before selling it.
This ratio is industry-specific and should be used to compare competitors. A company like Boeing will have a vastly different DIO than a company like Amazon where inventory turnover is high.
Days Payable Outstanding (DPO)
Days Payable Outstanding = (Accounts Payable / COGS) x 365
Days Payable Outstanding shows the time in days a business has to pay back its creditors. On the flip side, it also shows how long the company can utilize the cash before paying it back.
The longer a company can delay payments, the better.
Cash Conversion Cycle
Cash Conversion Cycle = DIO + DSO – DPO
Putting DIO, DSO and DPO together, you get the cash conversion cycle.
The entire cash conversion cycle is a measure of management effectiveness. The lower the better, and a great way to compare competitors.
For a full explanation as well as company comparisons and examples, check out the article on cash conversion cycle.
Turnover Ratios
Receivables Turnover = Revenue / Average Accounts Receivables
The receivables turnover ratio is one that is categorized as an activity ratio because it measures the company’s effectiveness in collecting its credit sales.
Inventory Turnover = COGS / Average of Inventory
Inventory is money. It costs money to buy, it costs money to just hold it because it takes up a lot of overhead if it isn’t cleared out. You waste shelf space, the product gets old and it may have to be sold at a fraction of the price just to get rid of it.
Inventory turnover is important for companies with physical products and is best used to compare against peers. After all, the inventory turnover for a retailer like Wal-Mart is going to be very different to a car company like Ford.
Average Age of Inventory (Days)
Average Age of Inventory = Average of Inventory / Revenue
The average age of inventory is just the inverse of Inventory Turnover.
I’ve separated the two because it is easier to visualize the inventory age in days. Let’s say that the inventory turnover for Safeway is 10. But it just makes it easier to visualize the inventory when it is described as 36.5 days instead of a turnover ratio of 10.
Intangibles to Book Value Ratio
This balance sheet metric is helpful in checking quality and health.
Unless a company holds a lot of valuable intellectual property or well-known brands, I like to see intangibles kept low. This is a simple balance sheet analysis to show how much of the company’s value is built on intangibles.
Intangibles to Book Value = Intangibles / Book Value
Inventory to Sales Ratio
Inventory to Sales = Inventory / Revenue
A rather simple and less used ratio. It is mostly useful when you track it year over year or every quarter.
The objective is to see how inventory is being managed as it will signal potential problems with cash flow.
An increase in the inventory to sales ratio can indicate that
- your investment in inventory is growing more rapidly than sales
- or sales are dropping
- your investment in inventory is shrinking in relation to sales
- sales are increasing
Capital Structure Ratios
Capital structure is looking at the company’s debt and equity. The following ratios all help to show you how much a company is using debt to run the business.
These are easy balance sheet ratios to understand and offer a quick check for red flags.
LT-Debt as % of Invested Capital = Long Term Debt / Invested Capital
ST-Debt as % of Invested Capital = Short Term Debt / Invested Capital
where,
Invested Capital = Shareholders Equity + Total Liabilities – Current Liabilities – Excess Cash
Debt to Equity Ratios
Watch how these ratios have trended in order to understand whether the company is in a difficult situation or not. If a company operates on high leverage and has maintained a high debt ratio, it is not as alarming as a company with a low debt ratio suddenly showing a spike in the debt ratio.
LT-Debt to Total Debt = Long Term Debt / Total Debt
The long-term debt ratio is an indicator that the company does not have enough cash to run future operations. Look into the deal for the debt, what the interest payments are, what level of operation the company has to achieve in order to remain within the debt covenant.
ST-Debt to Total Debt = Short Term Debt / Total Debt
If the short-term debt ratio is high, this is a big warning sign. The debt payment is coming due and has to be renegotiated or paid off with a new loan.
There are situations where a high short-term debt ratio will cause high levels of uncertainty and the stock to sell off.
Total Liabilities to Total Assets = Total Liabilities / Total Assets
A broad ratio to show the level of liabilities on the balance sheet compared to the assets.
Price to Working Capital = Price / Working Capital per Share
where,
Working Capital = Current Assets – Current Liabilities
Working capital is the absolute lifeblood of a company. Most fast-growing and successful businesses die due to a lack of working capital. That’s why most companies went public in the first place; to get more working capital from the public market.
A high working capital ratio shows whether the business can continue to operate without trouble.
For retailers, you would want to subtract inventory from the working capital equation to get a better picture.
Balance Sheet Ratios Download
Download the PDF of the 20 Balance Sheet Ratios to Measure a Company’s Health
