Financial Ratios Using Balance Sheet Amounts

We begin our discussion of financial ratios with five financial ratios that are calculated from amounts reported on a company’s balance sheet.

The following financial ratios are often labeled as liquidity ratios since they provide some indication of a company’s ability to pay its obligations when they come due:

• Ratio #1 Working capital
• Ratio #2 Current ratio
• Ratio #3 Quick (acid test) ratio

There are two additional financial ratios based on balance sheet amounts. These ratios provide information on a corporation’s use of debt or financial leverage:

• Ratio #4 Debt to equity ratio
• Ratio #5 Debt to total assets

Ratio #1 Working Capital

Working capital is defined as the amount remaining after subtracting a corporation’s total amount of current liabilities from the total amount of its current assets. (In most industries, current assets include cash and assets that are expected to turn to cash within one year. Current liabilities are the obligations that will be due within one year.)

The formula for determining the amount of working capital is:

Working capital = current assets – current liabilities

Generally, the larger the amount of working capital, the more likely a company will be able to pay its suppliers, lenders, employees, etc. when the amounts are due. It also means less stress when an unexpected problem arises.

The amount of working capital that a company needs will vary by industry (and could vary by company within the same industry). Here are some factors that determine the amount needed:

• Type of business (manufacturer, retailer, service provider, etc.)
• Size of the business
• Amount of sales on credit terms such as net 30 days
• Competition
• Composition of the current assets (cash is far different from inventory)
• Dates when the current liabilities must be paid (next week or 10 months from now)
• Age/condition of the assets used in the business (older equipment may require more repairs)
• Financing arrangements (such as an approved and unused line of credit)
• Emergencies that arise unexpectedly
• More insights can be found in our topic Working Capital and Liquidity

Here are two examples that illustrate how to calculate the amount of a company’s working capital:

Example 1A
ABC is a large manufacturing corporation with $4,200,000 of current assets and $4,000,000 of current liabilities. Therefore, ABC’s working capital is:

Working capital = current assets – current liabilities
Working capital = $4,200,000 – $4,000,000
Working capital = $200,000

ABC’s working capital of $200,000 seems too little for a large manufacturer having $4,000,000 of current liabilities coming due within the next year. However, if the company has a standard product that it produces continuously for a customer that pays upon delivery, the $200,000 of working capital may be adequate. On the other hand, if this manufacturer must carry a huge amount of inventory of raw materials and finished products and the demand for the products varies from month to month, the $200,000 may be far short of the amount needed.

Example 1B
Beta Company is an internet business with lots of sales every day to customers who pay with a credit card when ordering. If Beta Company has $35,000 of current assets and $20,000 of current liabilities, its working capital is:

Working capital = current assets – current liabilities
Working capital = $35,000 – $20,000
Working capital = $15,000

Since Beta Company is a service business, it is unlikely to have a large amount of inventory of goods as part of its current assets. Perhaps most of Beta’s current assets are in cash. If these assumptions are correct, Beta might operate comfortably with less than $15,000 of working capital.

Example 1A and Example 1B bring to light the difficulty in determining the amount of working capital needed by a specific business. For more insights, see our topic Working Capital and Liquidity.

Ratio #2 Current Ratio

The current ratio, which is sometimes referred to as the working capital ratio, is defined as a company’s total amount of current assets divided by the company’s total amount of current liabilities. Expressed as a formula, the current ratio is:

Current ratio = current assets / current liabilities

Generally, the larger the ratio of current assets to current liabilities the more likely the company will be able to pay its current liabilities when they come due.

The following factors are relevant for determining the appropriate current ratio for a company as well as working capital (Ratio #1):

• Type of business (manufacturer, retailer, service provider, etc.)
• Size of the business
• Amount of sales on credit terms such as net 30 days
• Competition
• Composition of the current assets (cash is far different from inventory)
• Dates when the current liabilities must be paid (next week or 10 months from now)
• Age/condition of the assets used in the business (older equipment may require more repairs)
• Financing arrangements (such as an approved and unused line of credit)
• Emergencies that arise unexpectedly
• More insights can be found in our topic Working Capital and Liquidity

Since current assets divided by current liabilities results in a ratio (unlike the amount of working capital), the current ratio can be compared to a smaller company’s current ratio or to a larger company’s current ratio within the same industry.

Example 2A
ABC is a large manufacturing corporation with $4,200,000 of current assets and $4,000,000 of current liabilities. Therefore, ABC’s current ratio is:

Current ratio = current assets / current liabilities
Current ratio = $4,200,000 / $4,000,000
Current ratio = 1.05 (or 1.05 to 1 or 1.05:1)

ABC’s current ratio of 1.05 seems small for a large manufacturer with $4,000,000 of current liabilities. In the past, many people believed that the ideal current ratio was 2 (having twice as many current assets as current liabilities). Today, we should consider many factors when attempting to find the optimum current ratio for a business. The factors for a manufacturer include:

• The consistency of its sales and production
• How fast customers pay
• Levels of inventory required
• Dates when current liabilities must be paid
• And many more factors. Our topic Working Capital and Liquidity provides additional insights.

Example 2B
Beta Company is an internet business with significant daily sales to customers who must pay with a credit card when ordering. If Beta Company had $35,000 of current assets and $20,000 of current liabilities, its current ratio at that moment would be:

Current ratio = current assets / current liabilities
Current ratio = $35,000 / $20,000
Current ratio = 1.75 (1.75 to 1 or 1.75:1)

Since Beta Company is not a manufacturer or retailer, it will have little or no inventory. If its current assets consist mainly of cash and receivables from long-time customers who pay promptly, Beta may operate with a ratio of 1.00 (or even less) if its revenues are consistent.

Ratio #3 Quick (Acid Test) Ratio

The quick ratio is commonly known as the acid test ratio. The quick ratio is more conservative than the current ratio because the amounts of a company’s inventory and prepaid expenses are not included. (It is assumed that inventory and prepaid expenses cannot be turned into cash quickly.)

As a result, only the company’s “quick” assets consisting of cash, cash equivalents, temporary investments, and accounts receivable are divided by the total amount of the company’s current liabilities. For companies with inventory (manufacturers, retailers, distributors) the quick ratio is viewed as a better indicator (than the current ratio) of those companies’ ability to pay their obligations when they come due.

The formula for the quick ratio is:

Quick ratio = (cash + cash equivalents + temp. investments + accounts receivable) / current liabilities

Whether a company’s quick ratio is sufficient will again depend on factors such as:

• The makeup of the quick assets
• How fast customers pay for the goods or services provided by the company
• The dates that the current liabilities must be paid
• Financing arrangements

Example 3A
To illustrate the quick ratio, assume that on December 31, a large manufacturing corporation has $4,200,000 of current assets and $4,000,000 of current liabilities. However, the $4,200,000 of current assets includes $2,600,000 of inventory and prepaid expenses. As a result, its “quick” assets (cash + cash equivalents + temporary investments + accounts receivable) amount to $1,600,000 ($4,200,000 – $2,600,000). The corporation’s quick ratio as of December 31 is calculated as follows:

Quick ratio = (cash + cash equivalents + temp. investments + accounts receivable) / current liabilities
Quick ratio = $1,600,000 / $4,000,000
Quick ratio = 0.40 (0.40 to 1 or 0.40:1)

Obviously, a manufacturer and retailer will have a quick ratio that is significantly smaller than its current ratio. This corporation’s quick ratio of 0.40 will require the business to get its inventory items sold in time to collect the cash needed to pay its current liabilities when they come due. This may or may not be a problem depending on the customers and the demand for the corporation’s goods.

Example 3B
Assume that Beta Company is an internet business with lots of sales every day and customers pay when ordering. Beta’s current assets of $35,000 includes $9,000 of inventory and $1,000 of prepaid expenses. Therefore, the amount of Beta’s “quick assets” (cash + cash equivalents + temporary investments + accounts receivable) is $25,000 ($35,000 – $9,000 – $1,000). If Beta Company has $20,000 of current liabilities, the calculation of its quick ratio is:

Quick ratio = quick assets / current liabilities
Quick ratio = $25,000 / $20,000
Quick ratio = 1.25 (1.25 to 1 or 1.25:1)

If Beta’s quick assets are mostly cash and temporary investments, it has a great quick ratio.

This concludes our discussion of the three financial ratios using the current asset and current liability amounts from the balance sheet. As mentioned earlier, you can learn more about these financial ratios in our topic Working Capital and Liquidity.

Next, we will look at two additional financial ratios that use balance sheet amounts. These financial ratios give us some insight on a corporation’s use of financial leverage.

Ratio #4 Debt to Equity Ratio

The debt to equity ratio relates a corporation’s total amount of liabilities to its total amount of stockholders’ equity.

The debt to equity ratio is calculated by dividing a company’s total amount of liabilities by its total amount of stockholders’ equity:

Debt to equity ratio = total liabilities / total stockholders’ equity

A corporation’s use of some debt is considered wise for the following reasons:

• Interest on debt is deductible from the taxable income of a U.S. corporation
• The cost of borrowed money (interest expense) is less than the cost of having additional shares of stock
• The corporation can acquire and control more assets without diluting its existing stockholders’ ownership interest

However, too much debt is risky because the corporation may not be able to obtain additional loans to cover the cost of unexpected problems.

Example 4A
Assume that on December 31, ABC Corporation had $4,200,000 of current assets and $5,800,000 of noncurrent (long-term) assets resulting in total assets of $10,000,000. ABC also had current liabilities of $4,000,000 and $3,200,000 of noncurrent liabilities resulting in total liabilities of $7,200,000. Its total stockholders’ equity was $2,800,000. Given this information, ABC Corporation’s debt to equity ratio on December 31 was:

Debt to equity ratio = total liabilities / total stockholders’ equity
Debt to equity ratio = $7,200,000 / $2,800,000
Debt to equity ratio = 2.57 (2.57 to 1 or 2.57:1)

As ABC’s debt to equity ratio of 2.57 indicates, the corporation is using a large amount of creditors’ money in relation to its stockholders’ money. We would say the company is highly leveraged and that could be a factor in whether the corporation can borrow more money if needed for an emergency or economic downturn.

One should look at the average debt to equity ratio for the industry in which ABC operates as well as the debt to equity ratio of its competitors to gain more insights.

Example 4B
Assume that Beta Company has the following: current assets of $35,000; noncurrent assets of $65,000; current liabilities of $20,000; noncurrent liabilities of $25,000; total stockholders’ equity of $55,000. Beta Company’s debt to equity ratio is calculated as follows:

Debt to equity ratio = total liabilities / total stockholders’ equity
Debt to equity ratio = $45,000 / $55,000
Debt to equity ratio = 0.82 (0.82 to 1 or 0.82:1)

Beta’s debt to equity ratio looks good in that it has used less of its creditors’ money than the amount of its owner’s money.

Ratio #5 Debt to Total Assets

The debt to total assets ratio is also an indicator of financial leverage. This ratio shows the percentage of a business’s assets that have been financed by debt/creditors. The remainder comes from the owners of the business. Generally, a lower ratio of debt to total assets is better since it is assumed that relatively less debt has less risk.

[Our discussion of the debt to equity ratio (Ratio #4 above), highlighted some of the pros and cons of using debt instead of equity when purchasing business assets.]

Recalling that debt means the company’s total amount of liabilities or the total amount owed to creditors, the debt to total assets ratio is calculated by dividing a company’s total amount of liabilities by its total amount of assets.

Here is the formula for the debt to total assets ratio:

Debt to total assets = total liabilities / total assets

Example 5A
ABC Corporation’s most recent balance sheet reported total assets of $10,000,000 and total liabilities of $7,200,000. ABC’s debt to total assets ratio as of the balance sheet date was:

Debt to total assets = total liabilities / total assets
Debt to total assets = $7,200,000 / $10,000,000
Debt to total assets = 0.72 or 72% (or 0.72 to 1 or 0.72:1)

This indicates that 72% of the cost of total assets reported on ABC’s balance sheet assets were financed by its lenders and other creditors. The remaining 28% were financed by ABC’s stockholders.

Whether 72% is a good debt to total assets ratio depends on the assets, the cost of the debt, and lots of unknown factors in the future.

A debt to total assets ratio of 72% may be acceptable at a growing company where long-term loans were needed to purchase labor saving equipment and construct more efficient facilities (instead of paying rent for inefficient facilities).

On the other hand, when the debt resulted from operating losses caused by declining demand and poor management, a debt to total assets ratio of 72% may be risky and may prevent the company from obtaining additional loans.

Example 5B
Beta Company’s recent balance sheet reported total assets of $100,000 and total liabilities of $45,000. Therefore, Beta Company’s debt to total assets ratio as of the date of the balance sheet was:

Debt to total assets = total liabilities / total assets
Debt to total assets = $45,000 / $100,000
Debt to total assets = 0.45 or 45% (or 0.45 to 1 or 0.45:1)

Whether 45% is a good ratio of debt to total assets depends on future conditions. However, as a general rule, a lower ratio of debt to total assets is considered better since there is less risk of loss for a lender and the company may be able to obtain additional loans if needed.