Know About Balance Sheet Ratios: Solvency, Liquidity, and Risk Metrics

After learning how to decode the Profit & Loss Statement, it's time to explore another crucial component of financial analysis balance sheet ratios. These ratios are vital for assessing a company’s long-term health, short-term strength, and operational risks. 

These ratios fall into three essential categories: 

• Solvency Ratios 

• Liquidity Ratios 

• Risk Ratios 

Solvency Ratios 

Solvency represents a company’s ability to meet its long-term obligations. These ratios measure financial stability and assess whether a business can sustain its debt with internally generated cash flows. Two key solvency indicators are: 

1. Debt-to-Equity Ratio 

This ratio compares the company’s long-term borrowings with shareholder equity. A higher value indicates reliance on external funds, increasing the potential for default if earnings dip. 

Formula: 
Debt/Equity = Long-Term Borrowings / Shareholder’s Equity 

Insight: 
The company's debt levels are stable and relatively low. This shows prudent financial management and low long-term default risk. 

2. Interest Coverage Ratio 

This reflects how easily a company can pay interest on its debt from operating profits (EBIT). A declining trend may indicate increasing debt stress. 

Formula: 
Interest Coverage = EBIT / Finance Costs 

Insight: 
Though the ratio has decreased over time due to higher borrowings, the current level still indicates a comfortable interest servicing ability. However, it’s wise to monitor this closely, especially in sectors prone to cyclical downturns. 

Liquidity Ratios 

Liquidity ratios gauge a firm’s capacity to cover its short-term obligations. Two critical ratios in this domain are: 

3. Current Ratio 

Also called the working capital ratio, it measures the availability of current assets to meet short-term liabilities. 

Formula: 
Current Ratio = Current Assets / Current Liabilities 

Insight: 
With the exception of FY20, likely impacted by the COVID-19 crisis, the ratio has remained above 1x, indicating healthy short-term liquidity. 

4. Quick Ratio 

Also known as the acid-test ratio, this metric excludes inventory from current assets to show how quickly obligations can be paid without selling stock. 

Formula: 
Quick Ratio = (Current Assets – Inventory) / Current Liabilities 

Insight: 
The quick ratio has been consistently below 1, except for FY18, indicating potential short-term funding gaps or slower collections. Improved receivables turnover could help strengthen this metric. 

Risk Ratios 

Risk ratios evaluate operational and financial sensitivity, focusing on how changes in sales and interest expenses impact profits. 

5. Operating Leverage 

This reflects the relationship between fixed costs and sales growth. High operating leverage means small sales changes can lead to significant profit swings. 

Formula: 
Operating Leverage = % Change in EBIT / % Change in Sales 

Insight: 
The company is showing strong operating leverage in FY21, likely due to fixed cost efficiency. However, in a downturn, this could reverse quickly if sales dip. 

6. Financial Leverage 

This ratio measures how changes in EBIT affect the bottom line. It reveals the impact of interest expenses on profitability. 

Formula: 
Financial Leverage = % Change in PAT / % Change in EBIT 

Insight: 
The company has steadily reduced financial leverage, indicating a more stable profit structure and reduced dependence on debt for earnings growth. 

Final Thoughts: What to Remember 

• Balance sheet ratios are powerful tools for evaluating a company’s long-term solvency, short-term liquidity, and financial stability. 

• Keep these formulas in your investing toolkit for better stock selection. 

• Platforms like m.Stock simplify access to such fundamental metrics, helping investors track and analyze them effortlessly.