Common-size balance sheets, liquidity and solvency ratios

What is a common-size balance sheet?

It restates every balance sheet line as a percentage of total assets. That strips out size, so a small company and a large one, or one company in two different years, can be compared on structure.

Vertical common-size analysis divides each item by total assets. The percentages for assets add to 100%, and so do those for liabilities and equity together. (Horizontal common-size analysis divides by a base-year value instead; the exam default is vertical.)

$$\text{Item \%} = \frac{\text{line item}}{\text{total assets}} \times 100$$

Common-size analysis

• Vertical Memorize each item ÷ total assets
  • Time series same company, different years
  • Cross-section different companies, same industry
• Horizontal Know the idea each item ÷ base-year value

Patterns tell you the business. A software company is heavy in cash and receivables, a utility in plant and long-term debt, a retailer in inventory and payables. Use the tool over time to see a trend, and across peers to spot who is different.

How do you judge liquidity?

Compare the assets that become cash soon with the obligations due soon. Liquidity is the ability to meet short-term commitments. Solvency (next section) is the ability to meet longer-term obligations.

Memorize

The three liquidity ratios differ by how strict the numerator is. The current ratio counts all current assets, the quick ratio excludes inventory and prepaid expenses, and the cash ratio counts only cash and marketable securities.

$$\text{Current} = \frac{\text{current assets}}{\text{current liabilities}}$$

$$\text{Quick} = \frac{\text{cash} + \text{marketable securities} + \text{receivables}}{\text{current liabilities}}$$

$$\text{Cash} = \frac{\text{cash} + \text{marketable securities}}{\text{current liabilities}}$$

How do you judge solvency?

Look at how the company is financed: how much debt, relative to equity and to assets. The debt-to-equity ratio , long-term debt-to-equity , the total debt ratio and the financial leverage ratio all rise as the company borrows more.

Memorize

$$\text{LT D/E} = \frac{\text{long-term debt}}{\text{total equity}}$$

$$\text{D/E} = \frac{\text{total debt}}{\text{total equity}}$$

$$\text{D/TA} = \frac{\text{total debt}}{\text{total assets}}$$

$$\text{FL} = \frac{\text{total assets}}{\text{total equity}}$$

“Debt” means interest-bearing short- and long-term borrowings. Accounts payable are not debt in these ratios, but always check how the question defines the term.

Balance sheet ratios

• Liquidity Memorize can it meet obligations over the next year?
  • Current ratio current assets ÷ current liabilities
  • Quick ratio excludes inventory and prepaids
  • Cash ratio cash and securities only
• Solvency Memorize who funds the company, and can it meet long-term obligations?
  • Debt-to-equity total debt ÷ equity
  • Long-term debt-to-equity long-term debt ÷ equity
  • Total debt ratio total debt ÷ total assets
  • Financial leverage total assets ÷ equity

Worked example: Vela Instruments

Here are all seven ratios from one balance sheet. Vela Instruments (USD m) has cash 120, marketable securities 60, receivables 220, inventory 300 and other current assets 50. Current assets are 750. Current liabilities are 500 (of which short-term debt is 100), long-term debt is 600, total assets are 2,000 and equity is 900.

Three formulas are asked from several sides, so practice rearranging them.

How do events move the ratios? Using Vela as the base:

Event	Current	Quick	Cash	D/E	D/TA	Leverage
Base	1.50	0.80	0.36	0.78	0.35	2.22
Pay 100 of short-term debt with cash	1.63	0.75	0.20	0.67	0.32	2.11
Buy 100 of inventory on credit	1.42	0.67	0.30	0.78	0.33	2.33
Issue 200 of equity for cash	1.90	1.20	0.76	0.64	0.32	2.00

Exam tip Liquidity asks whether the next 12 months are covered. Solvency asks who funds the company.

Go deeper Why adding the same amount to both sides pulls the current ratio toward 1

Buying 100 of inventory on credit adds 100 to current assets and 100 to current liabilities. Vela moves from 750 ÷ 500 = 1.50 to 850 ÷ 600 = 1.42. If the ratio starts below 1, the same move raises it. Paying a current liability from current assets does the reverse. So a company can nudge its year-end current ratio simply by choosing when to repay a supplier or a short-term loan.

Go deeper Limits of balance sheet ratios

Every number is a snapshot of a single day, and a company chooses that day. A current ratio of 1.50 says nothing about whether the inventory behind it will sell in a month or a year, which is why the quick and cash ratios sit next to it. Some lines are at cost, others at fair value, and some obligations never reach the balance sheet at all. Two companies using different accounting choices, or a group that mixes very different businesses, will not compare cleanly. Read a ratio against peers in the same industry and over several years before drawing a conclusion.