   Pricing  # How to Calculate Balance Sheet Ratios  Written by

Calculating the ratios from a business’s balance sheet may seem like a dry and academic exercise, but it is incredibly valuable. If used correctly, a balance sheet equation enables the discovery of three vitally important metrics – the liquidity, solvency and profitability of a business.

• The liquidity refers to the ability to turn assets into cash and what this would produce.

• The solvency is a measure of the cash or equivalent assets available to pay debts.

• The profitability is the net profit the business is generating based on the balance sheet equation.

## How the balance sheet equation works

A range of different accounting formula is available for use, but they are all based on the three segments of any balance sheet, which are:

• Assets – the full value of the assets owned by the business

• Liabilities – the full value of the debts owed by the business

• Shareholders’ equity – the full value of the assets owned by the shareholders. Find out how to calculate shareholder's equity.

## How to use the balance sheet equation

Most of the information needed to create a balance sheet equation is available on the balance sheet itself, but sometimes the income sheet of a business may need to be consulted.

## The balance sheet equation and profitability

The profitability ratio is a measure of the money made by a business and how that money is divided to keep the business running and to reward investors.

## How do you calculate profitability ratios?

Profitability ratios show how much money a company makes and how it distributes the cash to operate and reward investors. The equation is broken down into these aspects:

• Gross profit – the amount left over after sales have been calculated, and all selling and administrative costs have been deducted.

• Contribution margin – the contribution margin measures what is left after all variable expenses are deducted from sales and shows the ratio of profit remaining to pay for fixed expenses.

• Net profit ratio – the ratio of the proceeds from sales left after the expenses are paid.

• Return on equity – the ratio of income to shareholders’ equity that shows investors what the return on their investment is.

• Return on assets – a measure of how much the assets of a business are effectively being used to drive profits for that business.

## How do you calculate liquidity ratios?

The liquidity ratio aspect of the accounting equation is a measure of the speed with which the business can pay off debts through cash reserves or liquified assets. The equation can be broken down as follows:

• Current ratio – the percentage of current assets over current liabilities. As a figure it is slightly hampered by it including inventory, which is difficult to turn into cash quickly.

• Quick ratiosimilar to the current ratio, but with the inventory subtracted.

• Cash ratio – compares the cash held and easily convertible investments to demonstrate how quickly debts could be paid with either or both.

## How do you calculate solvency ratios?

The solvency ratio aspect of an accounting equation demonstrates how effectively a business could pay off its debts. The current ratio and quick ratio outlined above could be used for both liquidity and solvency tests.

The lower a debt-to-equity ratio is, the better placed the business is. A debt of £10 and equity of £30 would deliver a debt-to-equity ratio of 0.333 using the accounting equation, and any figure less than one is generally judged to be a good sign of how the business is being run.

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