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Balance Sheet Analysis
Introduction
In this section, we will look at some of the tools you can use in making an investment decision
from balance sheet information. If you are not familiar with balance sheets, you are advised to
first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of
the functions of a balance sheet and its components. We will cover the following topics here:
Why You Should Analyze a Balance Sheet
Liquidity Ratios
Leverage
Bankruptcy
Tying It All Together
A thorough analysis of a company's balance sheet is extremely important for both stock and bond
investors.
Why You Should Analyze a Balance Sheet
The analysis of a balance sheet can identify potential liquidity problems. These may signify the
company's inability to meet financial obligations. An investor could also spot the degree to which
a company is leveraged, or indebted. An overly leveraged company may have difficulties raising
future capital. Even more severe, they may be headed towards bankruptcy. These are just a few
of the danger signs that can be detected with careful analysis of a balance sheet.
Beyond liquidity and leverage, the following section will discuss other analysis such as working
capital and bankruptcy. As an investor, you will want to know if a company you are considering is
in danger of not being able to make its payments. After all, some of the company's obligations will
be to you if you choose to invest in it.
We will start with Liquidity Ratios, an important topic for all investors.
Liquidity Ratios
The following liquidity ratios are all designed to measure a company's ability to cover its short-
term obligations. Companies will generally pay their interest payments and other short-term debts
with current assets. Therefore, it is essential that a firm have an adequate surplus of current
assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be
able to make payments on their debts. To measure a firm's ability to meet such short-term
obligations, various ratios have been developed.
You will study the following balance sheet ratios:
Current Ratio
Acid Test (or Quick Ratio)
Working Capital
Leverage

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These tools will be invaluable in making wise investment decisions.
Current Ratio
The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to
which current assets exceed current liabilities, the easier a company can meet its short-term
obligations.
Current Assets
Current Ratio =
---------------------------
Current Liabilities
After calculating the Current Ratio for a company, you should compare it with other companies in
the same industry. A ratio lower than that of the industry average suggests that the company may
have liquidity problems. However, a significantly higher ratio may suggest that the company is not
efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of
the industry average.
Acid Test or Quick Ratio
The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it
excludes inventory. For this reason, it's also a more conservative ratio.
Current Assets Inventory
Acid test =
---------------------------
Current Liabilities
Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly
converted to cash. If this is the case, inventory should not be included as an asset that can be
used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within
close range to the industry average is desirable.
Working Capital
Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the
form of the equation:
Working Capital = Current Assets - Current Liabilities
This formula is very similar to the current ratio. The only difference is that it gives you a dollar
amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term
obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the
amount of Working Capital, the more security an investor can have that they will be able to meet
their financial obligations.
You have just learned about liquidity and the ratios used to measure this. Many times a company
does not have enough liquidity. This is often the cause of being over leveraged.

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 Balance Sheet Analysis Introduction In this section, we will look at some of the tools you can use in making an investment decision from balance sheet information. If you are not familiar with balance sheets, you are advised to first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of the functions of a balance sheet and its components. We will cover the following topics here: Why You Should Analyze a Balance Sheet Liquidity Ratios Leverage Bankruptcy Tying It All Together A thorough analysis of a company's balance sheet is extremely important for both stock and bond investors. Why You Should Analyze a Balance Sheet The analysis of a balance sheet can identify potential liquidity problems. These may signify the company's inability to meet financial obligations. An investor could also spot the degree to which a company is leveraged, or indebted. An overly leveraged company may have difficulties raising future capital. Even more severe, they may be headed towards bankruptcy. These are just a few of the danger signs that can be detected with careful analysis of a balance sheet. Beyond liquidity and leverage, the following section will discuss other analysis such as working capital and bankruptcy. As an investor, you will want to know if a company you are considering is in danger of not being able to make its payments. After all, some of the company's obligations will be to you if you choose to invest in it. We will start with ...
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