Every company has to keep up-to-date and correct financial records to prepare an income statement, balance sheet, and cash flow at the year-end. These financial statements offer insights into the current financial performance, the effect of marketing, and other policies reflected through sales, expense measurement, and the debt-paying capacity of the company. However, these statements only show numbers but not the relation and indication of financial elements. Such assessment requires studying metrics through ratio analysis. Ratio analysis is how firms learn the company's liquidity, solvency, profitability, and market value.
A balance sheet or position statement is an essential component of financial statements that reflects a company's assets, liabilities, and equity at a certain point. Ratio analysis offers specific metrics to comprehend the balance sheet elements. Let us take a look at ratios that only use balance sheet elements to indicate a company's financial standing:
Current Ratio:
The current ratio assesses the firm's liquidity position and shows the short-term debt-paying capacity. Its formula is: Current ratio= current assets/ current liabilities Current assets are inventory, debtors and receivables, short-term investments, prepaid expenses, etc. Current liabilities include outstanding expenses, creditors, and payables, etc. A 2:1 ratio is desirable.
Quick Ratio:
The quick ratio uses quick assets instead of current assets. Quick assets exclude inventory and prepaid expenses from current assets to indicate resources that will turn into cash immediately. Its formula for computation is: Quick ratio= Quick assets/ Current liabilities A 1:1 ratio is desirable
Debt to Equity Ratio:
The debt to equity ratio shows how much equity covers the debt portion of the company. It shows how much the business is dependent on debt financing. Its computation involves: Debt to equity ratio= Total liabilities/ Total shareholders' equity The ratio differs across industries. While some favour a low ratio, others may have a high ratio. A higher ratio involves a higher risk to shareholders. Firms can use project accounting software to compute these ratios.
It would help if you had a healthy solvency ratio analysis to stay operational. While liquidity indicates the company's ability to pay the short-term obligations, solvency shows whether the company can handle long-term dues. If it decreases over time, you may be in trouble. Its formula for computation is: Solvency ratio= (Net income+ Depreciation)/ Total liabilities Generally, a 20% solvency ratio is financially sound.