Hello Reader,

If you want to get more responsibilities in your finance team, I have one tip for you: don’t focus only on the P&L.

Instead, make sure you understand your balance sheet and how the business is impacting it.

In my experience, understanding my balance sheet is one of the factor which brought me to financial leadership positions.

To help you get better at Balance Sheet Analysis, I have prepared for you the 5 ratios you can use.

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There are many financial ratios to analyze your balance sheet, but I've singled out the best five ratios from my personal experience.

Top 5 Ratios

Here are the 5 most essential ratios which will help you get the most value from your balance sheet.

#1: Quick Ratio

Goal: Check the solvency of your company and how fast you can repay your short-term debts with your quick assets.

Formula: Quick Assets / Current Liabilities

(where Quick Assets = Current Assets – Inventory)

#2: Inventory Turnover

Goal: Measure how many months of inventory you have on your balance sheet.

Formula: Cost of Goods Sold / Average Inventory

Note: Use the Cost of Goods Sold (COGS) of the last 12 months to measure how many months of inventory you have.

For example, COGS of 100m$ / Inventory of 25m$ means that on average, your inventory will last a quarter (3 months).

#3: Asset Turnover

Goal: Check how much CAPEX you need for each $ earned. The higher the number, the fewer assets you need to make revenues.

Formula: Turnover / Net Tangible Assets

#4: Cash Conversion Cycle (CCC)

Goal: Check how many days you need to convert your cash out (from inventory into cash in (from sales)).

Formula: Days of Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

Note:

• Days of Inventory Outstanding = Average inventory for a month / Cost of Good Solds * 365
• Days Sales Outstanding = Receivables / Annual Revenue * 365
• Payable Days = Payables / Annual COGS * 365

#5: Working Capital

Goal: Measure the capital used to finance the daily operations.

Formula: Current Assets – Current Liabilities

Note: If you reduce it, you can free some capital to invest in CAPEX or new investments.

Bonus/Last Tips

• Contextual Comparison: Contextual Comparison is pivotal when exploring ratios, as their true significance is illuminated within the specific backdrop of your industry or sector. This approach allows you to unveil a deeper understanding of your financial position, revealing insights that might otherwise remain hidden.
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• Consistency Matters: Maintaining Consistency is not just a detail; it's a cornerstone for accurate insights. The reliability of your ratio analysis hinges on upholding uniformity in data sources and calculation methods. This consistency should extend across time frames used and the precision of your financial statements, establishing a solid foundation upon which dependable analysis can be built.
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• Harmonizing Ratio Combinations: Harmonizing Ratio Combinations amplify the value of ratios beyond their isolated numbers. Instead of relying solely on individual ratios, it's the synergy between complementary ratios that provides a comprehensive view of your financial health. An isolated ratio might offer a fragmentary perspective, but combining ratios in a meaningful way paints a panoramic picture of your overall well-being.
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• Consider External Factors: Incorporating External Factors is an imperative that should never be underestimated. External dynamics, encompassing economic shifts, regulatory changes, and technological progress, wield substantial influence over your ratios. Recognizing and integrating these factors into your analysis is essential for a nuanced understanding of what your ratios truly signify.
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• Future Projection: Future Projection draws upon historical ratios as a potent tool for envisioning your company's financial trajectory. By meticulously scrutinizing trends that span time, you empower yourself to anticipate potential challenges and opportunities that lie on the horizon. These insights serve as a guiding light for navigating the uncertain path ahead.

What Have We Learned Today?

• Ratios' Purpose: Ratios gauge financial performance, efficiency, and health. They cover liquidity, profitability, and operations.
• Key Ratios: Five vital ratios: Quick Ratio (solvency), Inventory Turnover (inventory management), Asset Turnover (asset efficiency), Cash Conversion Cycle (cash flow), and Working Capital (funding).
• Interpretation: Ratios rely on benchmarks, data consistency, and external factors. Combine ratios for holistic insights into financial status.
• Decisions: Ratios guide smart financial choices. They reveal improvement areas, enable competitor comparisons, and track trends over time.

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Nicolas

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