# Balance Sheet Analysis

Balance sheet analysis can be carried out using ratios based on information contained within the balance sheet. Understanding how to read a balance sheet and regular monitoring of the balance sheet ratios provides owners and management with a useful tool to help them manage their business more effectively.

By analyzing the balance sheet a business is able to see how it is performing relative to earlier accounting periods, and how its performance compares to other businesses in the industry.

### Example of Balance Sheet Analysis

Consider the example balance sheet below.

Balance Sheet
Amount
Cash 14,259
Accounts receivable 57,263
Inventory 1,764
Current assets 73,286
Long term assets 133,714
Total assets 207,000
Accounts payable 22,367
Other liabilities 21,291
Current liabilities 43,658
Long-term debt 39,793
Total liabilities 83,451
Capital 19,764
Retained earnings 103,785
Total equity 123,549
Total liabilities and equity 207,000

Numerous ratios can be calculated using balance sheet information, however, we shall concentrate on three main ratio analysis formulas which can be used to carry out balance sheet analysis.

The three financial ratios are:

• Current ratio
• Quick ratio
• Debt equity ratio
##### Current ratio

The current ratio is the ratio of current assets to current liabilities. More details on the calculation of the ratio can be found in our current ratio tutorial.

From the information above, the balance sheet analysis shows:

```Current ratio = Current assets / Current liabilities
Current ratio = 73,286 / 43,658
Current ratio = 1.68
```

The current ratio is often referred to as the working capital ratio or liquidity ratio as it is a measure of the solvency of the business and its ability to cover its expenses.

The current ratio is an indicator of whether or not a business can pay its liabilities as they fall due. Can it liquidate its current assets and have enough cash to pay its current liabilities.

Too high a ratio might indicate that too much cash is sitting idle or tied up in inventory and accounts receivable rather than being invested in the business.

In the above example the current assets are 1.68 times the current liabilities indicating that the business has adequate current assets which can be converted into cash in order to settle its current liabilities.

It depends on the nature of the business and the industry in which it operates, but a current ratio in the range of 1.00 to 2.00 is considered to be ‘normal’, and so our business balance sheet analysis indicates a satisfactory level for the ratio.

##### Quick ratio

The quick ratio is the ratio of current assets excluding inventory, to current liabilities. More details on the calculation of the ratio can be found in our quick ratio tutorial.

From the information above, the balance sheet analysis shows:

```Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Quick Ratio = (73,286 – 1,764) / 43,658
Quick Ratio = 1.64
```

The quick ratio is the same as the current ratio except that inventory is excluded from current assets. This is done on the basis that inventory might be more difficult to dispose of if liabilities need to be paid quickly.

The quick ratio is an acid test as to whether the business has sufficient cash and accounts receivable (which can be quickly turned into cash) to settle its current liabilities; for this reason it is sometimes referred to as the acid ratio.

In the above example the quick ratio is 1.64 meaning the business has more than adequate liquid assets with which to pay its current liabilities. A quick ratio in the region of 0.50 to 1.00 is considered to be ‘normal’, and our ratio of 1.64 might indicate that accounts receivable and therefore current assets are too high.

##### Debt Equity Ratio

The debt equity ratio is the ratio of the liabilities of a business to the equity. More details on the calculation of the ratio can be found in our debt equity ratio tutorial.

From the information above, the balance sheet analysis shows:

```Debt equity ratio = Liabilities / Equity
Debt equity ratio = 83,451 / 123,549
Debt equity ratio = 0.68
```

The debt equity ratio is sometimes referred to as the leverage ratio and indicates how much a business owes (debt) compared to how much the owners have invested (equity).

The higher the debt equity ratio the greater the risk to those who lent money to the business. A ratio of one indicates that the debt and equity are the same, anything above that and the lenders are taking more risk than the owners. Typically the lenders would want to see a debt equity ratio in the region of 0.50.

In the above example the debt equity ratio is 0.68 meaning the debt of the business is lower than the equity and therefore the business is seen as being adequately capitalized with a normal level of risk.

###### To analyze changes in the balance sheet of the business over time.

By calculating balance sheet ratios at the end of each accounting period, it is possible to monitor changes over time. For example, the following shows the balance sheets of the same business for two different financial periods.

Balance sheets for different financial periods
Period 1 Period 2
Cash 14,259 32,093
Accounts receivable 57,263 112,637
Inventory 1,764 4,563
Current assets 73,286 149,293
Long term assets 133,714 264,938
Total assets 207,000 414,231
Accounts payable 22,367 54,938
Other liabilities 21,291 46,383
Current liabilities 43,658 101,321
Long-term debt 39,793 82,089
Total liabilities 83,451 183,410
Capital 19,764 19,764
Retained earnings 103,785 211,057
Total equity 123,549 230,821
Total liabilities and equity 207,000 414,231

The balance sheets show that the business has grown between the two accounting periods and the absolute values of balance sheet item are significantly higher. As a direct comparison, it is difficult to establish any pattern or issues with the business. However, if balance sheet ratios calculations are carried out for the two periods the following balance sheet analysis comparison table can be produced.

Balance Sheet Analysis – Ratio comparison over time
Period 1 Period 2
Current ratio 1.68 1.47
Quick ratio 1.64 1.43
Debt equity ratio 0.68 0.79

The balance sheet analysis shows that both the current ratio and the quick ratio have fallen between the two periods indicating a reduction in the liquidity of the business as it expands. Possibly this is due to an inability of the business to maintain payments to suppliers as the business expands, resulting in an increase in current liabilities compared to the increase in current assets. The increase in total liabilities as the business takes on more debt has also results in an increase in the debt equity ratio.

Whilst the ratio changes between these two periods are not particularly significant, the business should keep monitoring them over time to ensure that it is adequately financed and that the liquidity does not continue to decline

By understanding a balance sheet, carrying out the balance sheet analysis, and monitoring the trend in the ratios it is easy to spot changes which can then hopefully be corrected earlier rather than later.

A similar process to that used above can be applied to compare two different businesses. In the example below. the balance sheets are for two businesses of differing sizes, operating in different industries.

Cash 14,259 5,269
Accounts receivable 57,263 7,229
Inventory 1,764 4,992
Current assets 73,286 17,490
Long term assets 133,714 7,788
Total assets 207,000 25,278
Accounts payable 22,367 11,145
Other liabilities 21,291 3,751
Current liabilities 43,658 14,896
Long-term debt 39,793 2,625
Total liabilities 83,451 17,521
Capital 19,764 5,802
Retained earnings 103,785 1,955
Total equity 123,549 7,757
Total liabilities and equity 207,000 25,278

Again while it is difficult to compare the absolute values of these two businesses, the balance sheet ratio calculations reveal the following results.

Balance Sheet Analysis – Ratio comparison between businesses
Current ratio 1.68 1.17
Quick ratio 1.64 0.84
Debt equity ratio 0.68 2.26

The second business shows a significantly lower current ratio and quick ratio indicating a lack of liquidity compared to the first.

In addition, the balance sheet analysis shows that the debt equity ratio for business two is 2.26 compared to 0.68 for business one. Clearly business two has a very high level of debt compared to equity, and on the face of it seems to be under-capitalized and therefore potentially a much riskier business.

This example is of two business in two very different industries and the balance sheet analysis clearly highlights the differences irrespective of their relative size. One has fairly ‘normal ratios’ while the other is showing signs of reduced liquidity and very high levels of debt compared to equity, indicating a much riskier concern.

The balance sheet analysis could equally well be used to compare businesses in the same industry or competitors. Alternatively, by using standard industry data, the business could be compared to industry averages to see whether it is performing above or below what is normal for the trade.