12 things to look for in a company’s balance sheet

Return on assets, net worth, debt to equity ratio etc., etc. We have heard and read about these terms, but do we really know what they represent? The July-September quarter is about to end and we will soon be in the midst of results season. This means that soon balance sheets of companies will begin to arrive, and it will be time for you, the investor, to understand the ratios that figure in them.

ET Wealth lists out the most important formulae and tells you why they matter.

1. Book value per share

Book value per share = Net worth/Number of outstanding shares

Why it is important: It is used for computing valuation ratios like price to book value ratio.
High book value per share (due to profits accumulated over the years) indicates a strong company.

2. Inventory turnover ratio
Inventory turnover ratio = Sales/Total inventory

Why it is important: Shows how efficiently the company manages its inventory.
The ratio should be compared between industry peers as it tends to be inflated for industries with very low inventories.

3. Return on net worth (RoNW)
Return on net worth (RoNW) = Profit after tax/Net Worth

Why it is important: Captures the net profit generated on shareholders’ funds.
Companies with low capital base (that don't need additional capital for growth) will show a higher ratio.

4. Cash holding per share
Cash holding per share = Total cash and cash equivalents/Number of outstanding shares

Why it is important: Indicates strength of company; Also used to arrive at valuation ratios.
A high amount of cash per share, if accumulated over the years, again indicates a strong company.

5. Total assets turnover ratio
Total assets turnover ratio = Sales/Total assets

Why it is important: Shows how efficiently the company manages its total assets.
Should be compared within industry because trading companies will show a better ratio here.

6. Return on total assets (RoA)
Return on total assets (RoA) = Profit after tax/Total assets

Why it is important: Captures the net profit generated on total assets.
More useful for financials because other ratios may not work there.

7. Debt to equity ratio
Debt to equity ratio = Total debt/Net worth

Why it is important: Indicates if a company is capable of fulfilling obligations to creditors.
A high debt to equity ratio is a warning signal, especially in situations like business downturns.

8. Return on capital employed
Return on capital employed (RoCE) = Earnings before interest and tax/Total capital employed

Why it is important: Captures the profit generated on total capital employed (including debt).
Companies with low capital base (those that don't need additional capital for growth) will display a higher ratio.

9. Free cash flow (FCF)
Free cash flow (FCF) = Net income + non cash expenses like depreciation & amortisation + change in working capital - capital expenditures

Why it is important: Indicates money left after company meets all operating and capital costs.
High free cash flow means a company is generating more cash than it needs for growth.

10. Net worth
Net worth = Equity capital + accumulated reserves - revaluation reserves - goodwill - accumulated loss
Why it is important: This captures the total funds held by shareholders. Due to accumulated losses, the net worth is negative for several companies.

11. Current ratio
Current ratio = Current assets/Current liabilities
Why it is important: Low current ratio (less than 1.5) indicates that a company may be getting into shortterm liquidity issues.

12. Quick ratio
Quick ratio = Current assets - inventories/Current liabilities
Why it is important: Also known as ‘acid test ratio’, very low quick ratio indicates that a company may be getting into short-term liquidity issues.