Learn about Balance Sheet Ratios

After P&L Statement, let’s turn to balance sheet ratios. They are:

• Solvency ratios
• Liquidity ratios
• Risk ratios

Solvency ratios

Being solvent refers to a company's capacity to pay off debts and interest by generating sufficient cash flows. This ratio, therefore, measures the company’s capacity to remain solvent in the long term. Solvency ratios are measured by debt to equity (debt/equity) and interest coverage and help understand if a company can service its debt in the long run.

Debt/equity ratio:

Debt to equity measures the long-term borrowings to the shareholder’s equity. A higher debt-equity ratio implies the company is dependent on more external borrowings than the shareholder’s funds, which creates a risk of default if the business does not create enough cash flows.

Formula: Total long-term borrowings/Total shareholder’s fund

A brief analysis:

The company is consistent with its debt/equity ratio and is very comfortably placed.

Interest coverage ratio:

This ratio measures how sufficient the profits generated by the company are to pay the interest on borrowings. If the ratio is higher, the company will comfortably pay the interest, and if it is lower, it signifies that there is a struggle to pay interest.

Formula- EBIT/Finance costs

A brief analysis:

The interest coverage ratio has declined steadily from 13.48x in March 2017 to 3.35x in Mar 2020. This is due to increased borrowings. From the above table of debt-equity, one can see that the company's borrowings have increased from Rs 834 crore to Rs 3660 crore.

Although the profits are 3x the interest expenses, it needs to be monitored. A cyclicality in the case of cyclical business or a drop in order flows in the case of infrastructure or heavy industry can affect profitability and, consequently, coverage.

Liquidity ratios

Liquidity ratios measure the company’s capability to generate immediate cash to pay off its current liabilities. There are two ratios with which the liquidity of a company is measured:

Current ratio :

Also known as the working capital ratio, this measures the current assets that are available to pay off the current liabilities. It is the sum of the total current assets divided by the total current liabilities.

Formula-Total current assets/Total current liabilities

A brief analysis:

Current ratio is consistently above 1x, except in March 2020. This may be due to the pandemic. Although there is no benchmark, the above ratio is comfortable. A ratio below 1 consistently implies that the company has issues managing its working capital and may resort to borrowings.

Quick ratio:

This is a ratio which measures how quickly the current assets can be converted into cash to pay off current liabilities. The current assets in this ratio exclude inventory. As inventory takes more time to become cash as it has to pass through two stages, selling and realising. The current assets minus the inventory is quick assets.

Formula: Quick assets/Current liabilities

A brief analysis:

Here, the quick ratio looks to be deficient historically. The company will have to improve its collection period or will need to borrow for working capital.

Risk ratios

They are employed to measure the business or operating risk and financial risk.

Operating leverage:

Operating risk is measured by the ratio known as operating leverage. Companies incur both fixed and variable costs in their operations or business activities. Having more fixed costs implies that the operating leverage is high. This means incremental sales will not affect the fixed cost and thereby lead to higher profits in the case of incremental sales.

However, having a higher fixed cost will mean a constant effort to generate volumes to cover the fixed costs. Having lower fixed costs will mean lower risk but lower profits and as sales increase variable costs also increase. However, to increase sales volume and business beyond a range, additional costs will have to be incurred.

Formula: % Change in EBIT / % Change in Sale

A brief analysis:

Over the years, this company has seen high operating leverage. This is because the company has most likely generated better volumes in sales. The operating leverage is likely to be very high in the years to come as the company has been investing intangible assets. However, if the sales volume decreases, there might be a risk of losses as the fixed cost may not get covered.

Financial leverage:

This means having more borrowed capital to finance assets that will enhance the return on equity. A higher ratio would imply the fixed costs are higher and would require higher volumes to cover fixed costs. Higher the ratio, the higher the leverage. The ratio measures how the interest element affects the profit after tax. A lower ratio would imply vice versa.

Formula: % Change in net profit / % Change in EBIT

A brief analysis:

Financial leverage has tapered down from 2.61x in March 2019 to 1.19x in March 2021. The company is comfortably placed.

Points to remember

• Balance sheets can reveal the financial status of a company and whether it is worth investing into
• You must keep these ratios handy while studying financial statements
• Calculations will help with a clear path ahead when it comes to your next steps