Tools To Analyze the Balance Sheets of High Growth Companies

Income and cash flow statements usually play a significant role in the financial analysis of a company, while the balance sheet is often largely ignored. However, the balance sheet can give valuable insights into a business’s liquidity and financial position, including its assets, liabilities, and performance.

This report is designed to give business owners, executives, and investors the tools and frameworks to analyze a company’s financial ratios in order to better read and understand the balance sheet in order to facilitate better decision making.

These ratios enable comparisons of data across companies, sectors, and industries. Tracking changes in these ratios over a period of time can help spot trends that may be developing in a company. Fourteen ratios are presented in this report; they are relatively easy to calculate but can provide deep insights into the performance of a business. Each ratio includes a “how to use” section that explains what each ratio indicates, an “industry perspective” section that describes how each ratio is relevant to different industries, and an “importance to investors section” that explains why a ratio matters to different investor profiles (like common equity holders, preferred equity holders, and debt lenders). 

A red/yellow/green ranking of the importance of the ratio-to-investor decision-making is presented in each section. 

Inventory Turnover

This measures how many times a company’s inventory is sold and replaced over a given time period.

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

How to Use It

A high inventory turnover ratio indicates effective inventory management with lower holding costs. A low ratio signals slow inventory turnover and unsold products, resulting in higher inventory expenses and reduced profits. To determine if the ratio is high or low, one may conduct a comparative analysis of a company’s inventory turnover to similar companies in the same industry. Comparing the current inventory turnover ratio to previous periods allows for the evaluation of long-term trends, potential seasonality impacts, and areas for improvement in a company’s inventory management efficiency.

Receivable Turnover Ratio

Indicates how quickly a company collects payments from customers and manages its accounts receivable.

Receivable Turnover Ratio = Total / Average Accounts Receivable

How to Use It

A high receivable turnover ratio signifies that the company collects cash more frequently, reflecting a stronger cash position that enables it to meet its financial obligations sooner. A low ratio indicates that the company is less effective in receiving payments or follows a more lenient credit policy. Calculating the average receivable over a year helps mitigate the influence of seasonal fluctuations that can distort financial ratios.

Payables Turnover Ratio

Also known as the Accounts Payable Turnover Ratio, this measures how quickly a company pays its suppliers. 

Payables Turnover Ratio = Total Non-Cash Purchases / Average Accounts Payable

How to Use It

A high payables turnover ratio implies that the company has a strong cash flow position, allowing it to meet its financial obligations, meaning that it takes less time to settle its debts with suppliers. A low payables turnover ratio could result in strained supplier relationships. Some industries have longer payment periods, and seasonal variations can impact the ratio. This can also be impacted by the size and strength of a company’s supplier base, i.e., supermarkets usually demand long credit terms as do many other large companies, putting cash strains on smaller companies.

Current Ratio

Indicates the company’s ability to pay short-term obligations (those due within one year).

Current Ratio = Current Assets / Current Liabilities

How to Use It

A current ratio greater than one indicates that a company has more current assets than current liabilities; a current ratio of less than one suggests that a company may struggle to cover its short-term debts with its available current assets. 

Quick Ratio

Indicates a company’s ability to quickly pay its short-term obligations using its current assets (also known as the “acid test” ratio).

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

How to Use It

Similar to the current ratio, but only considers immediate cash or cash equivalents, a high quick ratio suggests that a company has a strong ability to meet its short-term obligations without relying on the sale of inventory. A low quick ratio means that the company does not have enough liquid assets to cover its short-term liabilities. However, it may not always mean liquidity issues for the company; this could be seen in businesses that sell on a cash basis like restaurants and supermarkets.

Cash Ratio

A more conservative view of a company’s ability to quickly pay its short-term obligations using only its readily available cash and cash equivalents (excludes accounts receivable).

Cash Ratio = (Cash and Cash Equivalents) / Current Liabilities

How to Use It

The cash ratio is the ultimate liquidity test. If the company’s cash and cash equivalent equal its current liabilities, it means that the company has enough cash in its bank to pay off its short-term liabilities. 

Debt-to-Equity (D/E)

A debt-to-equity ratio compares the equity held by a company to its debt (an indication of a company’s ability to retain earnings).

Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity

How to Use It

Debt-to-equity ratio varies depending on the stage of the company’s growth and its industry sector. Newer and growing companies often use debt to fuel growth; conversely, a high D/E ratio in a mature company can be a sign of trouble that the firm will not be able to service its debts.

Debt-to-Service Coverage Ratio (DSCR)

A debt-to-service coverage ratio measures how much of a company’s cash flow is used to pay off debt: an indication of its ability to meet its debt servicing obligations.

DSCR = Earnings Before Interest and Taxes (EBIT) / Total Debt Service

How to Use It

A DSCR value represents the number of times a company’s operating income (EBITDA) covers its debt service obligations. A DSCR value greater than one indicates that the company’s operating income is sufficient to cover its debt payments, which is generally seen as a positive sign. The higher the DSCR, the more comfortably a company can meet its debt obligations.

Debt-to-Asset Ratio

Measures how much of a company’s assets are financed by debt.

Debt-to-Asset Ratio = Total Debt / Total Assets

How to Use It

An increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk. 

Return on Assets (ROA)

ROA measures how efficiently a company is using its assets to generate profit. 

Return on Assets (ROA) = Net Income / Total Assets

How to Use It

If the return on assets (ROA) goes up over time, it suggests that the company is getting better at making profits with every dollar it invests. If the ROA goes down, it might cause the company to over-invest in assets that didn’t generate more cash, which could be a red flag for the company. 

Return on Equity (ROE)

ROE measures how efficiently a company is using its equity to generate profit.

Return on Equity (ROE) = Net Income / Shareholder’s Equity

How to Use It

This ratio only takes into consideration the shareholders’ capital employed and helps assess how a company utilizes shareholder’s equity. ROE should be analyzed over a five-to-ten year period to develop a better picture of the growth of the company. A higher ROE means better returns for the shareholders with respect to what they have invested. A lower ROE implies that the company is less efficient in generating profits for its equity holders.

Gross Profit 

The profit a company generates from its core operating activities after subtracting the cost of goods sold (COGS).

Gross Profit = Revenue – Cost of Goods Sold (COGS)
Gross Profit Margin = Gross Profit / Revenue

How to Use It

Gross profit represents the residual sum obtained when deducting all manufacturing expenses. This ratio indicates the company’s profitability and shows as a credit balance on the trading account. However, the gross profit does not encompass factors such as taxes, additional expenses, or interest on loans. A higher ratio indicates that the company retains a larger proportion of its revenue as profit before accounting for other operating expenses and taxes. A lower ratio suggests that the company is struggling to generate profits from its core business activities. This could be due to higher production costs or pricing pressures. Higher sales can often lead to higher gross margins as the cost of assets is spread over more units and as economies of scales impact purchasing power.

Net Profit 

The profit a company has earned after deducting all expenses, taxes, interest, and costs from its total revenue or sales.

Net Profit = Total Revenue (or Sales) – Total Expenses
Net Profit Margin = Net Profit / Revenue

How to Use It

Net profit is the money a company has left after it has paid all its bills for a specific time. It shows as a credit balance on the income statement and helps understand how the company performed in a year compared to previous years. A higher ratio indicates that the company is efficient in converting a larger portion of its revenue into profit as it is effectively managing its costs and operations. A lower ratio suggests that the company is less efficient in converting its revenue into profit. 

Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)

EBITDA measures a company’s operating performance excluding interest, taxes, and non-cash expenses.

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA Margin = EBITDA/Revenue

How to Use It

A higher EBITDA indicates that a company is generating earnings from its core operations before accounting for interest, taxes, and non-cash expenses like depreciation and amortization. A lower EBITDA may indicate that a company’s core operations are less profitable or that it has significant interest expenses, taxes, or non-cash expenses that are reducing its net profit.

Balance Sheet and P&L Ratios: Relevance to Investors

The analysis of financial ratios is critical to assessing the financial health and performance of a company. These ratios serve as valuable tools for stakeholders to make informed decisions about investing, lending, or managing the company’s finances, assets, and liabilities, as well as its ability to meet its short-term and long-term obligations and generate profits.
However, to interpret these ratios, one should consider industry benchmarks, economic conditions, and the company’s business model. As the business landscape evolves, an understanding of these ratios is important to guide a company toward sustainable growth and financial stability.