How to Figure Ratios from Your Balance Sheet
How's your cash flow these days, compared with how it was a year or two ago? If you don't know, you may be missing important warning signs that your business is running into trouble. Using a few key ratios figured from your balance sheet can help you track your company's liquidity to avoid a cash crisis. You can also calculate your return on investment to see what your business is earning.
Current Ratio
One of the simplest liquidity ratios to calculate is the current ratio. This calculation will reveal whether your business has enough cash on hand to pay its current bills with cash to spare for unforeseen problems:
Current ratio = total current assets / total current liabilities
A good asset-to-liability ratio is at least 2 to 1. Obviously if your ratio is less than 1 to 1, you're in big trouble, as your bills already exceed your ability to pay.
Quick Ratio
To refine this a bit more, figure your quick ratio. This figure indicates whether your business could pay all its bills during a sudden reversal where sales drop sharply. Here's the formula:
Quick ratio = cash + cashable securities + receivables / total current liabilities
Be sure to calculate any penalties you would pay to prematurely cash in T-bills, certificates of deposit, or other investments. A 1-to-1 ratio or better is probably fine here, unless your accounts receivable is very large or tends to be collected unusually slowly. In this case you may need to build up your cash and investment reserves to keep your business secure in case of crisis.
Leverage Ratio
The leverage ratio measures how much debt your business has in relation to assets. The formula is this:
Leverage ratio = total liabilities / net worth
The higher your ratio of liabilities to net assets, the more risk your business carries and the more likely it is you're headed for trouble. As your leverage ratio rises, it may become increasingly difficult for you to borrow more money, as lenders may think you are incurring too much debt.
ROI
One final balance sheet ratio to know is return on investment. This ratio answers the important question of whether your business is making a better return on your money than you'd get if you put it in low-risk investments such as certificates of deposit. Here's the formula:
Return on investment = net before-tax profit / net worth
If your ROI percentage is lower than the going rate for CDs, say it's 4 percent at a time when CD returns are hitting 5 percent, you could spare yourself the day-to-day work of running a business and make more by investing your assets. Your ROI should be substantially better than investment interest rate to make doing business worthwhile.
Track these ratios each month to get a sense of company trends. If necessary, take steps to improve your business, such as raising prices, cutting costs, or perhaps postponing costly projects until your cash position improves.
See Using Income Statement Ratio Analysis to Stay on Track for another set of helpful ratios.
Business reporter Carol Tice contributes to several national and regional business publications.
