WFU Law School
Law & Valuation
3.2.2 Balance Sheet Analysis

Ratios

Net working capital =
Current assets - Current liabilities
Does the business have enough financial strength to continue operations for a reasonable period? A simple measure of short-term stability is whether current assets (cash, cash equivalents, and assets that should be reduced to cash within a year) exceed current liabilities (those that come due within a year).
Current ratio =
Current assets / Current liabilities
How adequate is working capital? The current ratio -- current assets divided by current liabilities -- reveals the company's ability to pay current debts. Financial analysts use a rule of thumb that an industrial company should have a current ratio of 2 to 1. But if the company has small inventory levels and the readily-collectible accounts receivable, a lower current ratio that is acceptable.

Acid test

  • Quick assets = Cash + marketable securities + current receivables
  • Net quick assets = Quick assets - current liabilities
  • Quick assets ratio = Quick assets / current liabilities
How would the company do in a financial pinch? Bankers and other short-term lenders to a business often look at quick assets which could be used in an emergency. Quick assets, unlike current assets, exclude inventories. The quick assets ratio is usually referred to as the acid test -- where a ratio of 1.0 or better shows the company could meet its current liabilities without liquidating inventory. A ratio less than 1.0 may not be a danger sign if anticipated cash flow (from sales) will meet the debt burden.
Book value of shares =
(Assets - Liabilities) / # Shares
What is the company's value, based on the balance sheet? Book value of shares is simply the value of a company's shares calculated from the balance sheet (the books) of the company. In our balance sheet above, book value would be $200 ($200,000 shareholders' equity / 1,000 shares outstanding). Book value rarely represents what somebody would pay for a corporation or event what its liquidation value might be, since it is based on historical cost and not earnings potential.
Asset coverage of debt =
(Total assets - Current liabilities) / Long-term debt
How secure is a long-term debt holder? Asset coverage of debt is a ratio of total assets minus current liabilities (that is, money available for long-term debtholders) divided by the amount of long-term debt, all computed at book value. This calculation does not take account of equity holders since the long-term debtholders are senior -- that is, they are entitled to full payment before shareholders get anything.
Debt/equity ratio =
Long-term debt / Total equity

How much of permanent capital is borrowed? The debt/equity ratio recognizes that long-term debt is a kind of permanent capitalization of the business. The debt/equity ratio shows the proportion of permanent capital that is borrowed to that contributed by shareholder or generated internally as retained earnings. This is important since borrowed capital must be paid interest, while dividends are usually discretionary. Large amounts of debt make the business more risky. A company with a high debt/equity ratio is said to be highly leveraged.

The debt/equity ratio gives lenders an idea of the equity "cushion" available to repay them in case of default. A high debt/equity ratio means a relatively small cushion and a greater risk the lender will not fully collect in the event of a default.

3.2.2 Balance Sheet Analysis

©2003 Professor Alan R. Palmiter

This page was last updated on: March 21, 2004