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# How to Calculate Balance Sheet Ratios

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Calculating the ratios from a businessâ€™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 â€“ 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.Â

## How the balance sheet equation worksÂ

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 â€“ the full value of the assets owned by the business

• Liabilities â€“ the full value of the debts owed by the business

• Shareholdersâ€™ equity â€“ 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.Â Â

## 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 â€“ the amount left over after sales have been calculated, and all selling and administrative costs have been deducted.Â

• Contribution margin â€“ 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.Â Â

• Net profit ratio â€“ the ratio of the proceeds from sales left after the expenses are paid.Â Â

• Return on equity â€“ the ratio of income to shareholdersâ€™ equity that shows investors what the return on their investment is.Â Â

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

## 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 â€“ 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.Â Â Â

• Quick ratio â€“ similar to the current ratio, but with the inventory subtracted.

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

## 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.Â

The lower a debt-to-equity ratio is, the better placed the business is. A debt of Â£10 and equity of Â£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.Â Â

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Calculating balance sheet ratios can feel like a complex part of running a business, and the same is true of taking payments from customers. Partnering with a payment platform likeÂ  GoCardless keeps this process as simple as possible and this includes the more complex aspects such as dealing with ad hoc payments or recurring payments.

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