Balance Sheet Analysis by Ratio Method

Various ratios are calculated to analyze the strength and weakness of a balance sheet of a company. The purpose of analyzing a balance sheet by investors is to make sure their investments in the company either by participating in the equity issue or by subscribing to the bonds yield them a nominal return in the first instance and then a growth in their investments.

1. Profitability Ratio: this is otherwise known as margin of profit is calculated by dividing operating income by sales
2. Earnings Ratio: this is otherwise known as earnings per share also as in the present day context majority of investors are equity investors. This is arrived at by dividing the net income earned by the number of equity shares floated by the company.
3. Quick Ratio: or quick assets ratio is the improved form of current ratio wherein the inventory is deducted from current assets and the resultant figure is divided by current liabilities. Quick ratio of 1:1 is considered a good ratio
4. Current Ratio: is arrived at by dividing current assets by current liabilities. A ratio of 2:1 is considered good.
5. Price to Earnings Ratio: of all the ratios this is the most important ratio based on which an investor evince interest in buying into the equity of the company. It is arrived at by dividing the market price of a share of the company by the earnings per share. The smaller the ratio the more attractive the buy decision as the opportunities for quick gains are more.
6. Price to Book value: this is arrived at by dividing the market price by the book value of the share. A ratio of 2:1 is considered reasonable.

Whenever investment decision is made all the major ratios are studied by a holistic approach to ensure better results.