The balance sheet key ratios

équilibre financier The balance sheet analysis and of the herebelow ratios inform us about the company financial balance.
  • Will your customer be able to pay you at the due dates of your invoices?
  • Is he solvent ?
  • Does he have sufficient liquidity to honor its short-term and medium / long term debts ?
This analysis will enable you to determine it.

Solvency Ratios

 Total liabilities / total equity: It’s showing the proportion between equities (internal financing) and debts (external financing). The more important the internal financing is, the lower is the risk of bankruptcy.
Who really owns the company ?
Shareholders Equity / (equity + liabilities) = %
Bank Bank loans / (equity + liabilities) = %
Creditors (including suppliers) short term liabilities / (equity + liabilities) = %
The total makes 100%. The higher % are in the high part, lower is the risk.
 Loan ratio: Loans payable > 1 year / Equities. Shows the banking debt level. The lower it is, the less the company is financially dependent on its banks.
 Should not exceed "1" in which case the banking dependence level is too high.
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Liquidity ratios (ability to honor its short term debt)

 Cash ratio: Accounts receivable + cash and cash equivalent - short term debts. This ratio is an excellent indicator about the capacity to refund the short term debts (thus to pay its suppliers).
  >1 solvency is good. <1 The company must sell its inventories to ensure the payment of its creditors. Tensions of treasury and delays of payment can appear.
 Daily Sales Outstanding (DSO): Accounts receivable / Gross revenues x 360. This indicator is showing if the accounts receivable is well or badly managed and if the company is able to be pay by its customers.
60 days if the accounts receivable are well managed (LME law in France restricts payment term up to 60 days maximum). Above 90 days is worrying especially if its customers are French (payment terms can be longer with foreigners customers).
 Daily Payable Outstanding (DPO): Accounts payable / cost of goods x 360. DPO is showing the payment behaviour with suppliers. Be careful with companies having a high DPO, you may be paid with delay.
This indicator should remain below 90 days.
 Inventory tunrover days: average inventory / cost of goods sold x 360 days. A ratio showing the days it takes to sell the inventory on hand.
More the result is low (< 20 days) more the company is controlling successfuly its purchasing processes and its WCR. If it is high (> 30 days), the WCR is increasing that may generate tensions of treasury. High inventory levels are unhealthy because they represent an investment with a rate of return of zero.

The financial statements falsifications

Some companies balk to publish financial statements representative of their real situation and falsify their balance sheet to post a situation in conformity with their wishes. By this way they try to:
  • hide financial problems which could worry their partners (customers, bankers, suppliers, shareholders etc).
  • diminish the net income in order to pay less taxes or to not reveal their business margin.
 In order to perform a relevant solvency analysis it is needed to detect this falsifications which can skew the assessment and the analysis which results from this.

Real example of balance sheet falsification

  Accounts receivable falsification: here is an assessment which shows seemingly a correct financial situation.
P & L K€ Assets K€ Equity & Liabilities K€
Gross revenues 12 625 Fixed assets 413 Equity 895
EBIT 516 Current assets* 5652 Liabilities 5170
Net income 265 *including accounts receivable 4983    

 If we look in details to the balance sheet we can see that the DSO is 144 days, which is very high.
Why ?
because this company underwent 2 unpaid for a total amount of 2 millions euros without reflecting it in their balance sheet and income statement which are in fact completely wrong.  Normally, the unpaid invoice should have been written off, which impact the EBIT and the Net income which become largely negative. The loss comes in reduction from equities to -1.1 million euros. The "fair" financial statements are completely modified like below:

P & L K€ Assets K€ Equity and liabilities K€
Gross revenues 12 625 Fixed assets 413 Equity -1105
EBIT -1484 Current assets* 3652 Liabilities 5170
Net income -1735 *including accounts receivable 2983    
Current assets are largely lower than the debts short terms. The company is unable to refund its debts and goes for bankruptcy (what happened a few months after the publication of the false financial statements).
Be attentive with the figures leaving the standards. A daily sales outstanding of 144 is sufficiently high to doubt on the accuracy of the accounts and to ask explanations to your customer.
A similar falsification is very common on the inventories valorisation: when a company overestimate inventories values the net income is higher than it should be as it should be impacted by the devaluation of obsolete inventories.
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