How To: Use the Balance Sheet and potentially the Income Statement you prepared earlier.

Step 1: Gather Data.

You’ll need the following from your Balance Sheet and Income Statement:

• • Current Assets, Inventory, Cash & Cash Equivalents
  • Current Liabilities, Total Liabilities, Total Equity
  • Operating Profit (EBIT) and Total Debt Service (annual principal + interest payments)

Step 2: Calculate Each Ratio.

• Calculate Current Ratio: Divide Current Assets by Current Liabilities.
  • Example for Yohannes (from his Balance Sheet):
    • Current Assets: ETB 120,000
    • Current Liabilities: ETB 30,000
    • Current Ratio = 120,000/30,000=4.0

• Calculate Quick Ratio: (Current Assets – Inventory) divided by Current Liabilities.
  • Example for Yohannes:
    • Current Assets – Inventory: ETB 120,000−60,000=ETB 60,000
    • Current Liabilities: ETB 30,000
    • Quick Ratio = 60,000/30,000=2.0

• Calculate Cash Ratio: Cash & Cash Equivalents divided by Current Liabilities.
  • Example for Yohannes:
    • Cash: ETB 45,000
    • Current Liabilities: ETB 30,000
    • Cash Ratio = 45,000/30,000=1.5

• Calculate Solvency Ratio: Total Assets divided by Total Liabilities.
  • Example for Yohannes:
    • Total Assets: ETB 310,000
    • Total Liabilities: ETB 110,000
    • Solvency Ratio = 310,000/110,000=2.82

• Calculate Debt-to-Equity Ratio: Total Debt divided by Total Equity.
  • Example for Yohannes:
    • Total Debt (Current + Non-Current Liabilities) = ETB 110,000
    • Total Equity = ETB 200,000
    • Debt-to-Equity Ratio = 110,000/200,000=0.55

• Calculate Debt Service Coverage Ratio (DSCR): (You’ll need annual Operating Profit (EBIT) and annual total debt service).
  • Example for Yohannes (Assumed Annual EBIT ETB 70,000, Annual Debt Service ETB 20,000):
    • DSCR = 70,000/20,000=3.5

Step 3: Interpret Your Results Against Benchmarks.

• Yohannes’s Liquidity Ratios:
  • Current Ratio (4.0): This is very strong, indicating he has plenty of current assets to cover his short-term debts. While creditors love this, a very high ratio could sometimes mean cash or inventory isn’t being used optimally.
  • Quick Ratio (2.0): Also very strong. Even without selling his inventory, Yohannes can easily pay off his short-term debts. This is excellent for creditworthiness.
  • Cash Ratio (1.5): This is exceptionally high! It means Yohannes has ETB 1.50 in cash for every ETB 1.00 of current liabilities. This shows great immediate liquidity but might suggest he has too much idle cash.

• Yohannes’s Solvency Ratios:
  • Solvency Ratio (2.82): Well above 1, indicating he has significantly more assets than liabilities. This shows a very healthy long-term financial position.
  • Debt-to-Equity Ratio (0.55): This is less than 1.0, which is fantastic! It means his business is financed more by his own equity than by debt, indicating low financial risk. Lenders would view this very favorably.
  • DSCR (3.5): This is very strong (well above 1.25). It means his operating income is 3.5 times what he needs to cover his annual debt payments. He has a solid ability to service his debts.

Overall Analysis for Yohannes: Yohannes’s business demonstrates excellent liquidity and solvency. He has ample cash and current assets to meet his short-term obligations, and his long-term debt structure is very sound, with more equity financing than debt. This puts him in a strong position for future growth and makes him a very attractive borrower for any expansion needs.