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Business News/ Money / Calculators/  De-jargoned: Balance sheet ratios
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De-jargoned: Balance sheet ratios

We need to concentrate on balance sheet-linked ratios such as turnover and leverage before investing

Abhijit Bhatlekar/MintPremium
Abhijit Bhatlekar/Mint

Equity investing requires you to pay attention to the financial health of the company whose stock you are buying. Usually, our focus is aimed at profitability and ratios such as price-earnings multiples, profit margins and expense ratios. But we also need to concentrate on balance sheet-linked ratios such as turnover and leverage. Here are three such ratios that we need to understand.

Asset turnover ratio

This ratio helps to understand how efficiently the assets of a company are being used. Assets help companies generate income or make sales, and if used efficiently, the proportion of sales can be increased. The ratio is calculated by dividing total revenues by total assets. Since the value of assets is a static figure at a given point in time, the total assets is an average of the holding in the beginning of the financial year and that at the end of the financial year. The higher the number, the better it is—it shows that assets are being used efficiently to generate revenue.

Similarly, return on assets is a ratio used to measure profitability against total assets and is calculated by dividing the net profit by average total assets.

Current ratio

This measures the company’s ability to manage its short-term assets, including inventory, and liabilities. It is calculated by dividing the current assets of the company with its current liabilities. It tells us whether the company is able to match its current liabilities or payments with its current assets or receivables. The higher the ratio, the better the ability. Anything less than 1 shows that the company can’t meet its current financial obligations through its current assets. This, however, doesn’t signal that the company has no cash (cash is considered a part of current assets), rather it shows the company’s inability to sell its products for cash and maintain an efficient operating cycle. This ratio is suitable for a manufacturing setup.

Debt-equity ratio

This is one of the most important balance sheet ratios. It measures the overall leverage of a company, and is calculated by dividing the total liabilities with shareholders’ equity.

Both the components of the ratio are part of a company’s overall capital that it uses to fund its operations. In terms of financial health, typically, a lower proportion of debt is suitable as debt adds to interest cost. But most successful businesses rely on a combination of debt and equity to fund growth. A high debt-equity ratio points to an aggressive growth path where operations are funded by debt. This can impact earnings if interest cost is variable from quarter to quarter. However, not using any debt may limit the company’s ability to expand. Typically, a debt-equity ratio of around 2 is considered healthy.

It should be seen in the context of the industry. For instance, non-banking finance companies can have this ratio as high as 5 or 6 times. For information technology, a low figure is preferred.

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Published: 07 Jul 2014, 07:16 PM IST
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