Information obtained from financial statements can help in developing a good measure of a business. And, financial statements are the most crucial document to derive that information.
The information contained in these statements helps an investor to understand if a company is doing well or not. Or, how prepared is it to survive during the unforeseen crisis in the future? Hence, an investor must know how to derive that information from these statements.
A financial statement comprises of three main statements:
1) Balance Sheet,
2) Profit and Loss, and
3) Cash Flow Statement.
What is a Balance Sheet?
A balance sheet is a statement of a company’s overall assets and its liabilities. As in, how much a company owns and how much it has to pay to others. A balance sheet is broken down into assets & liabilities (both current as well as non-current) and equity. A careful study of these entries indicates the financial strength of the company from a short-term as well as a long-term perspective.
What To Look For in a Company’s Balance Sheet?
A balance sheet helps in measuring a company’s efficiency based on four performance metrics:
1) Liquidity Ratios:
Liquidity ratios help in determining a company’s ability to pay its short-term debt obligations. Current ratio, quick ratio and cash ratio are the three popular liquidity ratios that are widely used to determine a company’s short-term liquidity position.
2) Efficiency Ratios:
A company needs to make maximum utilisation of minimum resources to improve its productivity. Efficiency ratios help in determining just the same. It helps in measuring a company’s ability to effectively use its resources, such as capital and assets, to produce maximum output.
Inventory turnover ratio and asset turnover ratio are the two most popular ratios used to measure how efficiently a company uses its resources.
Account receivable ratio, account payable ratio, and day’s sales in inventory are the other useful ratios that help to measure efficient use of resources.
3) Leverage Ratios
A business receives capital either in the form of equity or debt. Leverage ratios help in measuring the level of debt and a business’ ability to repay it.
While a certain level of debt helps a business to grow, excess debt starts hampering its prospects and results in the deterioration of financial health. Leverage ratios serve as a red light for an organisation to keep its debt levels under check.
Debt-to-Assets Ratio, Debt-to-Equity Ratio, Debt-to-Capital Ratio, Debt-to-EBITDA Ratio and Asset-to-Equity Ratio are the commonly used leverage ratios.
4) Returns Ratios
A company invests capital into a business and needs to generate returns on it to earn profit. Higher the returns, better the profitability. But for that, a company needs to put its funds to effective use.
Return ratios are the measures to help calculate returns that a company generates and evaluate the possibility of increasing them further.
Return on Investment (ROI), Return on Equity (ROE), Return on Capital Employed (ROCE), Return on Assets (ROA) are the popular examples of return ratios.
