How to Analyze a Balance Sheet
In order to understand and determine the financial health of an organization, it is a good idea to analyze the balance sheet. A few simple calculations can provide insight into the firm's liquidity and leverage. Read on to lean about the calculations and ratios that should be reviewed in order to analyze a balance sheet.
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Instructions
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1
Examine the Current Ratio. This ratio is an indication of the company's ability to pay its short-term obligations. It is calculated by:
Current Ratio = Current Assets divided by Current Liabilities
A lower than average industry current ratio may suggest a liquidity issue while a higher than industry average industry current ratio may suggest that the firm may not be using its' current funds efficiently.
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Review the quick ratio, otherwise know as the acid test.
Quick ratio = Current Assets (less inventory) divided by Current Liabilities.
In the denominator of the Quick Ratio the value of inventory is excluded. Because of this inventory exclusion, the quick ratio is more conservative than the current ratio. It includes the assumption the inventory cannot be turned into cash on hand quickly.
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3
Determine the working capital. This calculation is very similar to the current ratio but with working capital we are looking at dollars instead of ratios. The formula is:
Working Capital = Current Assets minus Current Liabilities
Again, this calculation gives us an indication of the firm's ability to meet its current debt.
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4
Look at the leverage. Here we are looking at the debt to worth ratio. Leverage gives us an indication of how the firm finances its assets. Basically, you are looking at the company's capital structure. Leverage is calculated as follows:
Leverage = Long-Term Debt divided by Total Equity
A high percentage here may be unsettling because it means that a firm is financing a large percentage of its assets with debt.
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Tips & Warnings
It is good to compare the balance sheet with other firms in the industry. Since balance sheets are a point in time, analyzing the balance sheet at regular intervals can help to spot trends.
Balance Sheets represent the company's health at one point in time. Therefore, the ratios calculated reflect the company's health at one point in time. Make sure you are using a current balance sheet to analyze the company's financial health.
