If you’ve ever run a balance sheet, you’ve probably felt pretty underwhelmed by the result.
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Unlike a profit and loss statement, which highlights your profitability, a balance sheet just looks like a fancy list of what your business owns and owes.
So how can you get anything useful out of a glorified list of my account balances? I’d like to introduce you to balance sheet ratios. (They’re way cooler than they sound, I promise.)
Balance sheet ratios are short formulas you can use to assess your financial health—just by looking at your balance sheet. They require very little math, yet lead to HUGE insights about your business.
Here are my favorite balance sheet ratios, detailed instructions on how to use them, and a free calculator to make your calculations easier.
Balance sheet ratios calculator
1. Net working capital
Use it to: Calculate how much money you have to put back into your business after you pay off your short-term debt.
Net working capital is how much money you’d have if you took all of your current assets and paid off all of your short-term debts. The money that’s left is what you have for your day-to-day operations and investments in your business. A negative net working capital means that your business doesn’t have money to sustain its operations and may need to sell its assets or take on more debt to survive.
Creditors and investors look at net working capital to see if your business can support its operating expenses and pay its current debt. A healthy amount of working capital shows investors that your business can stay afloat without taking on new debt. However, too much working capital could mean you’re not spending enough to grow your business.
To calculate your working capital, subtract your total current liabilities from your total current assets. (Technically, net working capital isn’t a ratio.)
Current assets include things like cash, accounts receivable (money others owe you), and inventory that you expect to sell within a year. Current liabilities include things like accounts payable (money you owe), wages, and debt due within a year.
Current assets – current liabilities = net working capital
For example, if you have $50,000 in current assets and $30,000 in current liabilities, it would look like this:
$50,000 – $30,000 = $20,000
In this example, you have $20,000 in working capital.
Keep in mind that working capital is not the same as cash flow. The current assets section of your balance sheet includes accounts receivables, which is money that others owe you. If you have $10,000 in open invoices, while you technically have $20,000 in working capital, $10,000 of that isn’t in cash—yet.
2. Current ratio and quick ratio
Use it to: Measure the liquidity of your company and see if you can pay for your short-term expenses with the liquid assets you have on hand.
Liquid assets are assets that easily convert into cash. If your business has high liquidity, it means you can quickly come up with the money to pay for an unexpected expense without going into debt.
The more liquid you are, the better. Liquidity shows lenders that you have money readily available to pay your business debts. This could lower your interest rates when you need to borrow money. If your business isn’t very liquid, it’s riskier for lenders to give you money, and you may have to pay more to borrow.
How to calculate your current and quick ratio
The current ratio takes into account all of your business’s current assets, including inventory. The formula for the current ratio is:
Current assets / current liabilities = current ratio
For example, if you have $13,000 in current assets and $6,000 in accounts payables and credit card debt, it would look like:
$13,000 / $6,000 = 2.1
This would make your current ratio 2.1.
The quick ratio is a more conservative view of your business’s financial health because it doesn’t include inventory. While inventory is an asset, just because you need money doesn’t mean you’ll be able to sell your stock right away. Selling off inventory takes time and energy, which is why it’s excluded from the quick ratio.
The quick ratio formula is:
(Total current assets – total current inventory) / total current liabilities = quick ratio
Let’s redo our example above using the quick ratio. You have $13,000 in current assets, and of that total, $3,000 is inventory. The calculation would be:
($13,000 – $3,000) / $6,000 = 1.67
Your quick ratio is 1.1, which is significantly lower than your current ratio of 2.3. This means a good amount of your liquidity is tied up in inventory.
For both the current ratio and quick ratio, the higher the number, the more financially secure your business. For both ratios, a number over one is considered financially healthy.
3. Debt to asset ratio
Use it to: Calculate how much of your business’s assets were purchased through debt rather than equity.
If you have a high debt to asset ratio, it means you’re mostly growing your business by taking on debt—not necessarily making money.
Creditors use your debt to asset ratio to see how risky it is to loan you money. The higher the ratio, the riskier you are, which makes it difficult to obtain a loan or low-interest rate. Investors also use this ratio to see how solvent your business is and if investing is a good idea.
How to calculate your debt to asset ratio
To calculate your debt to asset ratio, look at your balance sheet and divide your total liabilities by your total assets.
Total liabilities / total assets = debt to asset ratio
Let’s do an example: You have $10,000 in assets and $4,000 liabilities (debt). This means your debt to asset ratio is 40 percent:
$4,000 / $10,000 = 0.4
Is 0.4 a good debt to asset ratio? Here are some general benchmarks:
|Debt to asset ratio||Business risk level|
|Over 1||High—you have more debt than assets|
|0.6 and higher||High—you may have trouble borrowing money|
|0.4 and lower||Low|
4. Solvency ratio
Use it to: See if your business has the cash flow to pay off its long term debts while still meeting its short-term obligations.
While liquidity means that your finances are healthy enough to meet short-term expenses, solvency means that your finances are healthy enough to pay long-term debts and stay operational. Checking your solvency ratio is important because if you watch it decrease month over month, it means your business is in trouble.
It’s like a smoke detector for your finances—it alerts you that there might be a problem before your financial house goes up in flames.
Long-term creditors and investors look at your solvency ratio to determine the long-term health of your business and see if it’s likely to survive. A lender isn’t going to give you a five-year business loan if it doesn’t think your business will make it another two years. Similarly, an investor isn’t going to invest in your business if you’re headed toward bankruptcy.
How to calculate your solvency ratio
To calculate the solvency ratio, you need your balance sheet and your P&L. On your balance sheet, find your total net income and total liabilities.
On your P&L, locate your depreciation expense. Depreciation is how much your assets decrease in value over time. Since we’re looking at the long-term sustainability of your business, depreciation takes into account the need to replace your assets.
The solvency ratio is:
(Net income + depreciation) / total liabilities = solvency ratio
If you don’t have depreciation expenses, you can still calculate your solvency ratio by just using your net income.
Let’s walk through an example. You have $30,000 in net income and $7,000 in depreciation expenses. Your total liabilities are $20,000. The calculation is:
($30,000 + $7,000) / $20,000 = 1.85
Your solvency ratio is 1.85 or 185%. Generally, a solvency ratio of over 20% is considered financially sound. With a solvency ratio of 185%, you should easily be able to pay your long-term debts.
Now that you know how to decode your balance sheet, you can give your business a quick check-up with some fairly basic calculations. This will help you know if your business is actually doing well—or if the numbers just look good on paper.