Crucial ratios for analyzing the balance sheet

Liquidity Ratios:

1. Quick Ratio:

• It shows the ability to meet short-term obligations as we can monetize money very “quickly.”
• We can turn some of our current assets into cash or sell them if something goes wrong or if we need to.
• It is very conservative, but it shows a buffer on how fast the company can liquidate its “short-term” assets and monetize them to cover its needs (in the case of a tail-event).
• It is calculated as (Current Assets – Inventory)/Current Liabilities.
• As it is a ratio, the higher, the better.

2. Current Ratio:

• It shows the ability to meet short-term obligations as we can monetize money, but not as quickly as using a quick ratio.
• From this point of view, it is a less conservative ratio, but it is very important for figuring out how strong the balance sheet is.
• It is calculated as Current Assets / Current Liabilities.

Solvency Ratios

3. Debt to Equity:

• It shows the relative proportion of debt to shareholders’ equity, or in other words, it shows the proportion of equity from a debt perspective, which is used to finance a company’s assets.

4. Interest Coverage Ratio

• This number represents how many times the company can cover the interest payment from earnings (EBITDA)  in a given period.
• This number is crucial as low figures can be considered dangerous when cash flow stops or is disrupted (tail-event).
• It is calculated as EBIT (Earnings before Interest and Taxes)  / Interest Expense. Alternatively, as EBITDA/Interest Expense.
• It shows us that the company can cover its interest payments  X (number) times over its annual EBITDA.
• The higher, the better.
• In the case of a market slumpdown, plenty of companies can be seen “as great,” but if their cash flow declines significantly, it can cause big solvency problems. So look for companies with a minimum ratio of 4-5 or higher.

5. Solvency Ratio

• It shows if the company can meet its liabilities using its cash flow to meet its obligations.
• It is recommended to be at least 1; under 1 it is weak.
• Is calculated as (Net Income + Depreciation) / Total Liabilities.

Financial Leverage Ratio

6. Debt to Capital Ratio 

• This ratio measures the portion of debt relative to overall capital.
• We can calculate it as % debt on total capital in the company.
• Avert extreme results.
• Is calculated as (Debt / Debt + Equity).

7. Debt to Asset Ratio

• This ratio measures the portion of debt relative to the total assets.
• In other words, measure how many % of the company´s assets are financed via debt.
• It is calculated as Total Debt / Total Assets.
• The less, the better.
• % depends on the industry.

8. Financial Leverage Ratio

• This ratio measures the number of total assets relative to the equity.
• It should be between 1-2, but it depends on the interest rate and industry.
• It is calculated as Total Assets / Total Equity.