In the investment world, you often hear people use the term "a strong balance sheet." Many investors consider investing in companies with strong balance sheets because they are more likely to pay off their debts. A balance sheet has three components – assets, liabilities and shareholders' equity. A strong balance sheet indicates a company is liquid, which means it has enough cash on hand to handle its liabilities. Having a large amount of cash is not the only determining factor when deciding whether a balance sheet is strong. Many investors use liquidity ratios to determine the strength of a balance sheet.
Step 1
Examine the company's assets. Determine whether the company has enough current assets to pay its financial obligations. A company that has more liabilities than assets is considered financially weak. Even though a company may have a significant amount of current assets, it is not the only to factor to consider.
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Step 2
Calculate the current ratio by dividing the total of a company's current assets by current liabilities. The current ratio is used to measure a company's liquidity. A current ratio of 1 or greater is preferable when deciding the financial strength of a company, according to the Financial Speculation website.
Step 3
Calculate the quick ratio by subtracting inventory from current assets and dividing that result by current liabilities. The quick ratio is a more accurate measurement of a company's ability to pay its debts. A quick ratio higher than 1 means that company is in a good financial position.
Step 4
Calculate the cash-to-debt ratio by adding cash and short-term investments and dividing that total by current and long-term liabilities. It is important for a company to earn a high percentage of its cash from its operations and not from having a lot of debt. A favorable cash-to-debt ratio is anything equal to or exceeding 1.5.
Step 5
Calculate the debt-to-equity ratio by dividing the total amount of a company's liabilities by shareholders' equity. The debt-to-equity ratio determines the amount of debt and equity a company uses to purchase assets. If the ratio is lower than 1, it means that a company is purchasing most of its assets with equity, which shows financial strength.
Step 6
Examine past trends. To further determine the strength of a balance sheet, you should analyze positive and negative trends within a company. Determine whether important data on the balance sheet is improving or declining over time. Compare the financial data of the balance sheet to similar companies' balance sheets and industry ratios.
Tip
You can find the financial ratios of many public companies online for free at financial websites.
Warning
Avoid considering only one factor to determine the strength of a balance sheet.
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