Balance sheet ratios are a tool you can use to assess a company’s financial position at a specific point in time. Yes, the balance sheet shows you what the company owns (its assets), what it owes (its liabilities), and its shareholders’ equity. Ratios, on the other hand, can help you get a clearer picture of the company’s financial health by giving you more than just the basic information.
Read: A Complete Guide to Financial Statement Analysis for Strategy Makers
You can calculate a few key ratios and evaluate the company’s liquidity, leverage, and stability. As metrics, ratios help finance professionals understand the company’s position and find areas for improvement.
In this post, we’ll guide you through the 7 most important balance sheet ratios, explain why they matter, and show you how to use them.
Before learning more about balance sheet ratios, read: Classified Balance Sheet: Definition, Components, and Examples
Why Balance Sheet Ratios Are Important?
Balance sheet ratios are extremely useful in giving you more details about a company’s financial health. They help keep the company stable, manage risk, and make strategic plans.
They Help Manage Cash Flow
The current ratio and quick ratio, for example, tell you if the company has enough liquid assets to cover short-term obligations. Using horizontal analysis to track these ratios over time helps spot liquidity trends and plan the cash flow better.
They Keep Financing in Check
Ratios such as debt-to-equity and debt-to-assets reveal how much the company relies on debt. Keeping debt levels balanced keeps the company flexible and lowers risk in volatile periods.
They Measure Long-Term Resilience
Equity ratio and asset coverage ratio highlight financial resilience. They show if the company’s resources are being used effectively and if its financial structure supports long-term goals.
7 Key Balance Sheet Ratios
In this section, we’ll break down the seven most important balance sheet ratios. We’ll look at each one, how it’s calculated, and how it applies in real-world decision-making.
Current Ratio
The current ratio tells you if a company has enough assets to cover its short-term debts. It’s a quick check on liquidity. When it’s higher, the company can probably cover its immediate expenses. A lower ratio could mean cash flow issues.
Formula:
Current Ratio = Current Assets / Current Liabilities
Analysts use the current ratio to check if the company has enough cash or assets that can quickly be turned into cash to cover day-to-day expenses.
In industries where inventory turns over quickly during peak seasons (FMCG), it’s crucial to have a stable current ratio. Nestle, for example, often aims for a current ratio between 1.1 and 1.5. This keeps their operations running smoothly, and they don’t overcommit resources.
For more on breaking down current assets and liabilities, check out our guide on Account Analysis.
Quick Ratio (Acid-Test Ratio)
The quick ratio, or acid-test ratio, shows if a company can cover its short-term debts without relying on inventory. It’s a more conservative measure of liquidity in comparison to the current ratio because it only considers the most liquid assets (ones that can be quickly converted to cash). A higher quick ratio means the company can handle unexpected expenses. A lower ratio may mean potential cash flow challenges.
Formula:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Analysts use it to see if the company can meet its immediate obligations with cash or cash-like assets.
In industries that have specialized inventory (pharmaceuticals), this ratio is especially useful for providing liquidity. Pfizer, for example, often aims for a quick ratio between 1.0 and 1.5 to be sure it can manage short-term expenses without relying on inventory, because it may take longer to convert it into cash.
Debt-to-Equity Ratio
The debt-to-equity ratio shows how much a company relies on debt to finance its operations compared to equity. It measures financial leverage, assessing the company’s risk level. A higher ratio means that the company is financed by debt more heavily, which is also known as high gearing. High gearing is a sign of a greater financial risk, especially in volatile markets.
Formula:
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
Analysts use this ratio to evaluate how well a company balances its approach to financing. Too much debt can make a company vulnerable during economic downturns. A balanced ratio can help the company grow steadily.
In capital-intensive industries such as telecoms, where a lot of money is needed to maintain infrastructure, companies tend to have higher debt-to-equity ratios. For example, Verizon aims to be in the 1.5-3.0 range. This means that it can fund infrastructure investments, and still manage financial risk.
For more info on how debt and equity changes affect financials, read our guide on the 3-Statement Financial Model.
Debt-to-Assets Ratio
The debt-to-assets ratio shows how much of a company’s assets are financed by debt. It’s a measure of leverage and often signals financial risk. If the ratio is high, the company relies heavily on debt, which can be risky if asset values drop.
Formula:
Debt-to-Assets Ratio = Total Debt / Total Assets
Finance teams track this ratio to make sure they can manage debt levels. It’s especially useful during tough economic times. A balanced debt-to-assets ratio helps protect the company from being overly dependent on borrowed money, reducing the risk of financial strain.
In industries like manufacturing, the goal is to keep a debt-to-assets ratio between 30% and 50%. For a detailed look at balance sheet items as percentages of total assets, check out our guide on Vertical Financial Analysis.
Working Capital
Working capital shows if a company has enough assets to cover day-to-day expenses. Ideally, it will be positive in most industries. But, in sectors like retail, companies often work with negative working capital. In those cases, it’s a sign of efficient cash management. Big retailers can, for example, negotiate payment terms with their suppliers that enable them to hold onto their cash for longer.
Formula:
Working Capital = Current Assets – Current Liabilities
Keeping the working capital in check helps companies make sure they have enough liquidity to cover routine costs and seasonal changes. To keep operations running smoothly, pharmaceutical distributors like AmerisourceBergen usually aim for a working capital between 1.5 and 2.5.
For more on tracking ratios like working capital over time, see our guide on Comparative Balance Sheet Analysis.
Equity Ratio
The equity ratio shows how much of a company’s assets are financed by shareholders instead of debt. It tells you how financially stable and independent from external financing a company is. A higher equity ratio means the company relies more on its own funds, which is always good for growth.
Formula:
Equity Ratio = Total Equity / Total Assets
Companies look at the equity ratio to understand how financially strong they are. This can be crucial when they plan for expansion. A strong ratio allows them to invest in growth without relying too much on debt.
Tech giants like Apple aim for an equity ratio between 40% and 60%, which helps them balance stability with flexibility.
Asset Coverage Ratio
The asset coverage ratio shows if a company has enough tangible assets to cover its debts. It’s a measure of financial security, indicating how well a company’s assets can back up its obligations. A higher ratio means the company is in a stronger position to cover its debt with assets if needed.
Formula:
Asset Coverage Ratio = (Total Assets – Intangible Assets – Current Liabilities) / Total Debt
Balance Sheet Ratios Benchmarks Across Industries
In the table below, you can see some general benchmark ranges for the ratios we mentioned here. Each sector has different standards, based on totally different asset requirements, cash flow cycles, and risk tolerances, and it’s important to look at each ratio in that context.
It’s important to mention that balance sheet ratios make the most sense when you track them over time and look at trends. They can tell you a lot about the company’s financial health and potential problems. Only tracking changes over time tells the full story.
Putting Balance Sheet Ratios to Work
Balance sheet ratios are powerful tools for guiding your financial strategy.
You should use them regularly to assess your company’s liquidity, manage debt levels, and make sure your company is financially stable.
By tracking changes over time and comparing them to industry benchmarks, you’ll gain insight into areas that need adjustment, identify potential risks early, and make informed decisions that support growth and resilience.
If you want to learn more about ratios and find out if your business is built to last, visit: Liquidity and Solvency Ratios – Metrics for Your Business’ Survival.
