Looking at Balance Sheet Ratios
In the previous two posts on Managing Franchise Performance, we focused on the balance sheet, how to read it, and what I look for in this financial statement. In this post, I will focus on key ratios that I find helpful when analyzing the balance sheet. It’s especially useful in a franchise business where you can compare your ratios to other locations without revealing the actual numbers. The following are two commonly used ratios that can be calculated from a balance sheet:
1. Current ratio: Current assets / Current liabilities
The current ratio is a financial ratio that measures a company’s ability to pay off its short-term liabilities (debts due within one year) with its short-term assets (assets that can be easily converted into cash within one year). The formula for calculating the current ratio takes the following from the balance sheet:
Current Ratio = Current Assets / Current Liabilities
e.g., if a company has $200,000 in current assets and $100,000 in current liabilities, its current ratio would be 2:
Current Ratio = $200,000 / $100,000 = 2
A current ratio of 2 shows that the company has twice as many current assets as current liabilities. This is generally considered a good indication of short-term liquidity. However, a high current ratio may also suggest that the company is not efficiently utilizing its current assets. Such as cash and inventory, to generate revenue or growth.
2. Debt-to-equity ratio: Total liabilities / Total equity
The debt-to-equity ratio is a financial ratio that compares a company’s total liabilities to its total equity. It measures how much a company relies on debt financing to fund its operations compared to its own equity. The formula for calculating the debt-to-equity ratio takes the following from the balance sheet:
Debt-to-Equity Ratio = Total Liabilities / Total Equity
e.g., if a company has $500,000 in total liabilities and $1,000,000 in total equity, its debt-to-equity ratio would be 0.5:
Debt-to-Equity Ratio = $500,000 / $1,000,000 = 0.5
A debt-to-equity ratio of 0.5 means that for every dollar of equity the company has, it owes 50 cents in debt. I use this ratio to evaluate a company’s financial leverage. It will tell how much it relies on debt financing to fund its operations. A high debt-to-equity ratio may indicate that a company is taking on too much debt. This puts it at risk of financial distress or bankruptcy. In contrast, a low ratio may suggest that a company is not taking advantage of debt financing opportunities to grow and expand its operations.
Analyzing the current and debt-to-equity ratios in conjunction with other financial ratios and qualitative factors is important to get a more comprehensive picture of a company’s financial health. In the next post, I will discuss other ratios that can be derived from the balance sheet to better understand the performance of your franchise business.
Here are some helpful links in the Managing Franchise Performance series:
