Accounting

Understanding Balance Sheet Ratios

USA Furniture’s Balance Sheet as of December 31, 2007 (Sums in $)

Assets

Liabilities + Equity

Current Assets

Current Liabilities

Cash

5,000

AP

8,000

Inventory (furniture)

2,000

Total Current Liabilities

8,000

AR

3,000

Long-term Liabilities

Total Current Assets

10,000

Fixed assets

Bank loans

7,000

Total Long-term Liabilities

7,000

Equipment

6,000

Total Liabilities:

15,000

Furniture

4,000

Equity

Building

10,000

Share capital

10,000

Total Fixed Assets

20,000

Retained earnings

5,000

Total Equity

15,000

Total

30,000

Total

30,000


Current RatioRatio Data

Ratio Data:

Current ratio= Total current Assets/ Total current Liabilities For USA Furniture: $ 10,000/$ 8,000= 1.25


The purpose of the ratio:

The purpose of the ratio is to evaluate a company’s ability to pay its liabilities in the near future (up to one year).

 

Significance of the ratio:

  • When total current assets are greater than total current liabilities, the current ratio is greater than 1.

  • When total current assets are less than total current liabilities, the current ratio is less than 1.

  • When total current assets are equal to total current liabilities, the current ratio equals 1.

In order to thoroughly grasp the significance of the current ratio, assume that all three items included as current assets (cash, inventory, and accounts receivable) of USA Furniture will be turned into cash within six months (the inventory will become furniture and be sold and all accounts receivable will repay their full debts to the company). At the same time, the company must pay all its current liabilities within six months (payment to suppliers).

If the current ratio is greater than 1, the company will be able to pay off all of its current liabilities (payment of $8,000 to suppliers) from its current assets ($10,000).

If the current ratio is exactly 1, the slightest mishap in turning current assets into cash is liable to create difficulty in paying the company’s current liabilities. When the current ratio is 2, the company’s managers can enjoy peace of mind.

In short, the more the current ratio exceeds 1, the more current assets exceed current liabilities and the greater the company’s ability to pay off its current liabilities (debts coming due in 1 year or less).

A surplus of current assets in excess of current liabilities is also called positive working capital. The further a company’s current ratio is below 1, the more its current liabilities exceed its current assets, making the company less able to pay its debts in the near future.

Interpretation of the results:

The current ratios of industrial companies are usually expected to be between 1 and 2. A current ratio slightly below 1 is still no reason for a company to declare “bankruptcy”. If the ratio is significantly lower than 1 (0.5 or lower), however, it should serve as a warning about the company’s ability to make payments in the near future. When the current ratio is very high (3 or greater), it means that the company is easily able to repay its debts in the near future. On the other hand, it may also indicate a lack of efficiency in the company and that it holds too many current assets (particularly if the cash assets or numbers of inventory items are substantial) , which should instead be invested in more profitable instruments.


Quick Ratio

Ratio Data:

Quick Rtio = Total current assets net of inventory/ total current Liabilities For USA Furniture: ($ 10,000- $ 2,000)/ $ 8,000= 1


Purpose of the ratio

The quick ratio is similar to the current ratio. It is designed to evaluate a company’s ability to pay its current liabilities under a particularly restrictive assumption that its inventory cannot be turned into cash during the current year for purposes of paying debts coming due.


Significance of the ratio

When the quick ratio is equal to 1, as in the case of USA Furniture, this indicates that the company is able to pay off all of its current liabilities using assets that it can immediately turn into cash (in this case, cash in the bank and credit to customers), without having to sell its inventory.


Interpretation of the results

The quick ratios of industrial companies are usually expected to be around or slightly lower than 1. If the ratio is significantly lower than 1 (0.4 or lower), it should serve as a warning about the company’s ability to make payments in the near future.

As with the current ratio, when the quick ratio is too high (2 or greater), this indicates that the company has too many liquid assets and perhaps should divert some of them to more profitable instruments.

 

Equity-Balance Sheet Total Ratio

Ratio data:

Equity - Balance Sheet Total Rtio=

(Equity/ Balalnce sheet total)x 100

For USA Furniture:

( $ 15,000/ $ 30,000)X 100= 50%


Purpose of the ratio

This ratio is designed to evaluate the company’s debt burden. This ratio is usually calculated in percentages, which is why the results are multiplied by 100.

Significance of the ratio

This ratio measures the degree to which a company relies on its internal resources (equity) and the degree to which it relies on external sources (liabilities) in order to finance its activities.

For example, if the ratio is 30%, this means that 30% of the company’s assets are financed through equity. The company’s remaining assets (70%) are financed through liabilities. There are no other possibilities.

In accounting, when a company relies too much on external sources to finance its activity, it is usually said to have too great a degree of “financial leverage”.

Interpretation of the results

In industrial sectors, the ratio of equity to balance sheet total should usually be around 50%. When the ratio is lower than 20%, it should serve as a warning because such a ratio means that the company is relying primarily on external loans.

In the banking and insurance sectors, on the other hand, a ratio of 20% is considered very high. The usual ratio in these sectors is 8-15%.

Understanding Balance Sheet Ratios5100Understanding Balance Sheet Ratios