Balance Sheet Ratios, Definition and Use for Financial Analysis

Balance sheet ratios are a fundamental tool for the financial analysis of companies. These numerical indicators provide crucial data on the economic health, profitability and financial strength of a company. The use of balance sheet ratios allows for an in-depth evaluation of company performance, from different points of view, allowing you to compare results over time and with other companies in the sector.

In short, knowing balance sheet ratios is essential for those who deal with company management, considering that the work of specific teams passes through this information. Here, then, what are balance sheet ratios, their meaning and how important they are for reading and analyzing company balance sheets.

What are balance sheet ratios

The balance sheet ratios, also known as balance sheet quotients, are a fundamental tool for the financial analysis of companies. These numerical indicators are obtained from the reclassified financial statement and have a dual characteristic: they allow for the formulation of an opinion on the economic-financial profile of the company and are calculated by comparing two balance sheet values through a division.

The purpose of balance sheet ratios is, therefore, to detect whether a company is able to reach economic equilibrium. In this sense, there are two conditions to satisfy: revenues must exceed - or at least match - the volume of costs and the company must reach adequate financial power.

Balance sheet analysis by ratios, or "ratio analysis", is an investigation technique that re-elaborates the information contained in the financial statements in order to understand the evolution, the state of health and future scenarios of a company.

More in depth, this analysis moves along three lines: the patrimonial one, in which the structure and financial autonomy are investigated, the one relating to liquidity, useful for determining whether a company is able to honor its debts, and the profitability one, which presents some of the most well-known indicators in the field.

Main types of indices

As we have anticipated, therefore, balance sheet indices can be divided into three large categories, which all have different basic characteristics (and utilities).

• Profitability indices: they express in percentage the extent to which the income remunerates the capital contributed or the sales revenues achieved. Among these, the ROI (Return on Investment) and the ROE (Return on Equity) are particularly relevant for evaluating the profitability of invested capital and net assets.
• Liquidity indices: they reflect the financial situation of the company, usually referred to the short term. These indicators allow to evaluate the ability of the company to promptly cope with the monetary outflows deriving from management.
• Financial structure indices: they express the composition of the company capital, both as investments and as financing. capital strength ratios, in particular, are used to assess the adequacy of the amount of equity contributed by owners in comparison to the means contributed by third parties.

The combined use of these ratios allows for a complete balance sheet analysis, offering a 360-degree view of the company both at the end of the financial year and in the medium and long term. It is important to underline that the analysis must always be carried out over a time span of several years and with a comparison to the average values of the reference sector to obtain an accurate and significant assessment.

What are balance sheet ratios?

The interpretation and use of balance sheet ratios require an in-depth understanding of the company and sector context, as well as the ability to integrate different sources of information to obtain a complete and accurate view of the economic and financial situation of the company. First of all, it is essential to know what balance sheet ratios are, what they represent and how they are used, also based on the needs and prospects of the analysis itself.

Profitability ratios

Profitability ratios are fundamental tools for evaluating a company’s efficiency and economic performance. These indicators provide crucial information on the company’s ability to generate profits in relation to the resources employed. Among the main profitability ratios, ROE, ROI and ROS play a particularly important role in balance sheet analysis.

• ROI: this ratio – an acronym for Return on Investment – is calculated by dividing the operating income by the invested capital, consequently determining how much the latter yields. Based on the value measured by the indicator, there are three scenarios that can materialize: the operating income is higher than the invested capital, so the investment yields more than the cost of money; operating income and invested capital are equal, thus nullifying the investment; operating income is lower than invested capital, which determines the need to turn off investments in order not to lose further money.

• ROE: acronym for Return on Equity, this index has the same function as the one just illustrated, but turns the spotlight on the capital invested by shareholders. Recently associated with the weakness of the Italian banking system, the index is obtained with the following formula: net income divided by equity.

• ROA: abbreviation for Return on Assets, this indicator measures the profitability of investments, also differing from ROI. In fact, ROA takes into account the entire assets of a company, with a formula that states: profit before financial charges divided by total assets.

• ROS: the Return on Sales measures the profit margin on sales by comparing – as highlighted by the formula – the operating income with the turnover.

Finally, there are two other types of indicators of corporate profitability:

• the AT, which is calculated by dividing the turnover by the invested capital (logically, a high AT is a good sign for a company);
• the Leverage, which measures the degree of indebtedness of a company.

The combined analysis of these profitability indices provides a complete view of the economic performance of the company, allowing to evaluate the efficiency in the management of resources, the ability to generate profits and the sustainability of the business model in the long term.

Financial and equity ratios

Financial and equity ratios, on the other hand, are fundamental tools for assessing the solidity and liquidity of a company. These indicators provide crucial information on the capital structure and the ability of the company to meet its financial commitments.

This is a macro-category that is useful to divide into two groups.

• Structural analysis: in this category we find the indexes for the analysis of the rigidity of capital sources, useful for determining the degree of financial coverage of activities with equity and long-term debt. In this case, a high value reduces the risk for the company of finding itself in the condition of not being able to honor its debts. Then there is the index relating to the analysis of the elasticity of investments, which is obtained from the ratio between current assets and total assets. Finally, the indicators on the rigidity of investments which detect the impact of fixed assets on total investments.
• Financial autonomy analysis: in this field there are three reference indices. First, the one that measures the degree of coverage of fixed assets, the value of which is obtained by adding the debts from long-term fixed assets to the net capital, and dividing the result by the net fixed assets. Then there is an index that measures the degree of coverage of fixed assets, which is measured by dividing the net capital by the net fixed assets. Finally, the indicator relating to asset coverage, which measures the company’s ability to meet investments with its own capital. In this case, the net capital is divided by the activity, then multiplying the result by one hundred.

Liquidity ratio

The liquidity ratio, also known as quick ratio or acid test, measures the company’s ability to meet short-term financial commitments using the most liquid assets.

In this field, there are two reference indicators.

• General liquidity ratio: this indicator highlights the ability of a company to cover liabilities compared to current assets. To obtain this parameter, it is necessary to divide the current assets by short-term debts.
• Primary liquidity ratio: that is, the coverage rate of liabilities with immediate liquidity. The formula is obtained by subtracting the warehouse stock from the current assets, and dividing the whole by the current liabilities.

How to analyze the ratios over time

The temporal analysis of the balance sheet ratios is essential to understand the evolution of the economic-financial situation of a company.

By examining ratios over a series of consecutive financial statements, it is possible to identify trends and patterns that may reveal improvements or deteriorations in different areas of company management.

For example, a steady increase in ROI (Return on Investment) over the years could indicate an improvement in operating efficiency and the ability to generate profits. On the contrary, a progressive decline in the liquidity ratio could signal emerging problems in the company’s ability to meet its short-term obligations.

It is important to consider that the time analysis must be conducted over a period of at least three years to obtain a meaningful view of the trends in progress. Furthermore, it is essential to contextualize the changes in the ratios with specific company events or market conditions that may have influenced the results.

Comparison with industry benchmarks

Comparing balance sheet ratios with industry benchmarks is another crucial aspect of financial analysis. This approach allows you to evaluate the company’s performance compared to its competitors and the industry average, providing valuable information on the competitive positioning of the company.

To make an effective comparison, it is essential to select appropriate benchmarks that accurately reflect the characteristics of the industry and the size of the company being analyzed. For example, for an SME in the manufacturing sector, it would be more appropriate to use the average indices of other SMEs in the same sector as a reference rather than those of large multinationals.

When comparing with benchmarks, it is important to consider not only the absolute values of the indices, but also their variations over time. A company may have indices that are lower than the industry average, but if it is showing constant improvement, this could be a positive sign for the future.

Original article published on Money.it Italy. Original title: Indici di bilancio, definizione e uso per l’analisi finanziaria