Balance sheet analysis can help us evaluate a company’s liquidity and solvency. A balance sheet can be used to analyze a company’s capital structure and ability to pay liabilities.
In a vertical common-size balance sheet, all balance sheet items are expressed as a percentage of total assets. Common-size statements are useful in comparing a company’s balance sheet composition over time (time-series analysis) and across companies in the same industry. An example of a common-size balance sheet is shown in the figure below for Everest Inc.
|Cash and cash equivalents||10.81%||13.12%|
|Short-term marketable securities||1.24%||0.62%|
|Other financial assets||1.24%||1.21%|
|Other current assets||3.37%||2.14%|
|Property, plant and equipment||38.76%||40.06%|
|Deferred tax assets||0.11%||0.08%|
|Other non- current assets||0.03%||0.02%|
|EQUITY and LIABILITIES|
|Other current liabilities||24.29%||24.42%|
|Deferred tax liabilities||4.01%||4.20%|
|Other long-term liabilities||0.12%||0.13%|
|Equity and Liabilities||100.00%||100.00%|
Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us about a company’s ability to meet current liabilities, while solvency ratios tell us about a company’s ability to meet long-term and other obligations. They also help us evaluate a company’s financial risk and leverage. The following table summarizes some liquidity ratios. The last column shows the relevant ratios for Everest Inc. for 2015.
|Liquidity Ratios||Calculation||Ratios for Everest Inc. for 2015|
|Current||Current assets ÷ Current liabilities||
|Quick (acid test)||(Cash + Marketable securities + Receivables) ÷ Current liabilities||
|Cash||(Cash + Marketable securities) ÷ Current liabilities||
Solvency ratios help to evaluate:
|Solvency Ratios||Calculation||Ratios for Everest Inc. for 2015|
|Long-term debt-to-equity||Total long-term debt ÷ Total equity||0.004|
|Debt-to-equity||Total debt ÷ Total equity||0.012|
|Total debt-to-assets||Total debt ÷ Total assets||0.007|
|Financial leverage||Total assets ÷ Total equity||1.69|
It is important for analysts to remember that ratio analysis requires judgment. For example, current ratio is only a rough measure of liquidity. In addition, ratios are sensitive to end of period financing and operating decisions that can potentially impact current asset and current liability amounts. Analysts should also evaluate ratios in the context of a company’s industry. This requires an examination of the entire operations of a company, its competitors, and the external economic and industry setting.