To answer the question in the title, this article defines, explains, and provides examples of all the importance balance sheet ratios.

Current Ratio

The current ratio can be calculated as follows:

Current ratio = Current assets / Current liabilities

In this formula:

  • Current assets: Cash in hand, cash at bank, bills receivable, sundry debtors, inventories, work-in-progress, and prepaid expenses
  • Current liabilities: Bills payable, sundry creditors, and sundry outstanding expenses

Quick Ratio (or Acid Test Ratio or Liquid Ratio)

The term liquidity refers to the ability of a company to pay its short-term liabilities as and when they are due for payment. Out of current assets, inventories and prepaid expenses are not included because these cannot be converted into cash easily.

Therefore, to calculate the quick ratio, you can use the following formula:

Quick ratio = (Current assets – Stocks prepaid) / Current liabilities

Example 1

Calculate the quick ratio from the balance sheet shown below.

$ $
Bank loan 200,000 Land and buildings 590,000
Creditors 300,000 Stock in trade 270,000
Bills payable 40,000 Debtors 140,000
Outstanding exp. 20,000 Cash in hand / Bank 250,000
8% debentures 400,000 Marketable securities 300,000
Plant / mach. funds 600,000 Prepaid expense (Ins) 10,000
1,560,000 1,560,000

Quick ratio = Quick assets / Current liabilities
Quick assets = $140,000 + 250,000 + 300,000 = $690,000
Current liabilities = $300,000 + 40,000 + 20,000 = $360,000
Quick ratio = 690,000 / 360,000 = 1.916 times

Hint: A bank loan is a long-term liability, while a bank overdraft is considered a current liability.

Quick Assets: Don’t include stock and prepaid expenses.

Example 2

Calculate current assets and current liabilities when the current ratio is 2.5 and working capital is $180,000.

Solution

Working capital = Current assets – Current liabilities
Current Ratio = CA : CL
= 2.5:1

Therefore:

180,000 / 1.5 = 120,000

CA = $120,000 x 2.5 = $30,000

CL = $120,000 x 1 = $120,000

Example 3

Calculate current assets, liquid assets, and inventory from the following data:

  • Current ratio: 2.5:1
  • Acid test ratio: 1.5:1
  • Current liabilities: $50,000

Solution

To calculate current assets:

Current ratio = Current assets / Current liabilities
2.5 = Current assets / 50,000
Current assets = 2.5 x 50,000
Current assets = $125,000

To calculate liquid assets:

Acid test ratio = Liquid assets / Current liabilities
1.5 = Liquid assets / 50,000
Liquid assets = 1.5 x 50,000 = $75,000

To calculate inventory:

Inventory = Current assets – Liquid assets
= $125,000 – 75,000 = $50,000

Debt-to-Equity Ratio

This ratio is a claim of creditors to the assets of the organization. It is calculated by dividing total assets (i.e., current assets and long-term assets) by tangible network.

When the debt-to-equity ratio is high, it means that creditors have invested more in a business than the owners, and the creditors will suffer more in adverse times than the owners. Therefore, creditors prefer low debt-to-equity ratios.

To calculate the debt-to-equity ratio, use the following formula:

Debt-to-equity ratio = Outsiders’ funds / Shareholders’ funds

An alternative version of this formula is:

Debt-to-equity ratio = External equities / Internal equities

Proprietary Ratio (or Equity Ratio)

This ratio establishes the relationship between shareholders’ funds and total assets of the firm. It is useful for evaluating the long-term solvency of a company. Shareholders’ funds include equity, preference share capital, profits/losses, reserves, and surplus.

The equity ratio is calculated as follows:

Equity ratio = Shareholders’ funds / Total assets

Example

Shareholders’ funds amounts to $400,000 and total assets are $600,000. Using this information, the equity ratio is calculated as follows:

Equity ratio = 400,000 / 600,000 = 2:3

Comment: A high equity ratio is an indicator of the long-term solvency position of a company.

Solvency Ratio (or Ratio of Total Liabilities to Total Assets)

The solvency ratio is calculated using the following formula:

Solvency ratio = Total liabilities to outsiders / Total assets

Example

Suppose that total liabilities are $400,000 and total assets are $800,000. Therefore, to calculate the solvency ratio, we perform the following:

Solvency ratio = 400,000 / 800,000 = 1:2

Comment: The lower the ratio of total liabilities to total assets, the better the company’s position.

Fixed Assets to Net Worth Ratio (or Fixed Assets to Proprietors Fund)

This ratio is useful in establishing a relationship between fixed assets and shareholders’ funds (i.e., share capital reserves and retained earnings). It is calculated as follows:

Fixed assets to net worth ratio = (Fixed assets – Depreciation) / Shareholders’ funds

Example

Suppose that the depreciated book value of fixed assets is $800,000 and shareholders’ funds amount to $400,000. In this case, the fixed assets to net worth ratio is calculated in the following way:

= 800,000 / 400,000 = 2:1

Comment: When this ratio indicates how the funds are used, the best criteria is that fixed assets should be greater than shareholders’ funds.

Ratio of Current Assets to Proprietor’s Fund

This ratio is calculated by dividing the total of current assets by the shareholder’s fund. In other words:

Ratio of current assets to proprietor’s fund = Current assets / Shareholder’s funds

Example

Suppose that current assets are $400,000 and shareholders’ funds amount to $800,000. The ratio would be calculated as follows:

= 400,000 / 800,000 = 1:2

Comment: This ratio reflects the extent to which proprietor’s funds are invested in current assets.

Debt-Service Coverage Ratio (or Interest Coverage Ratio)

This ratio focuses on the debt-serving capacity of a firm. It is popularly known as the interest coverage ratio or fixed charges cover. The ratio is calculated by dividing earnings before tax and interest (EBIT) by fixed interest charges, namely:

Interest coverage ratio = EBIT / Fixed interest charges

Example 1

The net profit (after tax) of a corporation is $150,000 and its fixed interest on long-term borrowing is $20,000. The rate of income tax is 60%.

The interest coverage ratio is calculated as follows:

Interest coverage ratio = EBIT / Fixed interest charges

= (150,000 + Tax 90,000 + Interest 20,000) / 20,000

= $260,000 / 20,000

= 13 times

Example 2

A company’s EBIT is $1,500,000. The details of the company’s borrowings are:

  • 12% long-term loan: 3,000,000
  • Working capital:
    • Borrowing 15% from bank: $25,00,000
    • Public borrowing 10%: $20,00,000

The company’s sales are increasing and, consequently, it needs to borrow a further $2,000,000 from the bank. In this case, EBIT will increase by 25%.

Required: Calculate the change in the interest coverage ratio after the additional borrowing.

Solution

Interest on Borrowing $
(i) Long-term loan of 12% on 3,000,000 360,000
(ii) Bank borrowing of 15% on 2,500,000 375,000
(iii) Public borrowing of 10% on 2,000,000 200,000
Total interest payable 935,000

Interest coverage ratio = EBIT / Total interest liability

= 1,500,000 / 935,000 = 1.60 times

When additional borrowing of $20,00,000 is taken:

(2,000,000 x 15) / 100 = 300,000 (interest)

Thus, interest liability will be 9,35,000 + 300,000 = 1,235,000

Tax will increase by 25%

Thus, (1,500,000 x 20) / 100 = $300,000

= 1,500,000 + 300,000

= $1,800,000

New change rates = 1,800,000 / 1,235,000 = 1.45 times

True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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