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Balance sheet and ratios

In this chapter: Asset, liability, equity classifications · Liquidity, solvency, profitability ratios · DuPont analysis

~3 min readLayer 4 · Professional CertificationsFree

Balance sheet: snapshot of firm's financial position. Ratios make comparisons across firms and time. DuPont decomposes return on equity into drivers — fundamental analyst tool.

Foundation

Balance Sheet: Assets = Liabilities + Equity Assets: • Current (cash, receivables, inventory) — within 12 months • Non-current (PP&E, intangibles, long-term investments) Liabilities: • Current (payables, short-term debt) • Non-current (long-term debt, deferred tax) Equity: • Paid-in capital, retained earnings, treasury stock Key ratios: Liquidity: Current Ratio (CA/CL), Quick Ratio ((CA−Inv)/CL) Solvency: D/E, Debt-to-Assets, Interest Coverage (EBIT/Interest) Profitability: Gross Margin, Operating Margin, ROE, ROA Activity: Asset Turnover, Inventory Turnover, Receivables Days

Deep Dive

DuPont decomposition (3-step): ROE = Net Margin × Asset Turnover × Leverage = (NI/Sales) × (Sales/Assets) × (Assets/Equity) Decomposes return drivers. High ROE from leverage is fragile; from margins/turnover is durable. DuPont 5-step further: ROE = Tax Burden × Interest Burden × EBIT Margin × Asset Turnover × Leverage Working Capital = CA − CL. Days metrics: • Days Sales Outstanding (DSO) = AR/Sales × 365 • Days Inventory Outstanding (DIO) = Inventory/COGS × 365 • Days Payable Outstanding (DPO) = AP/COGS × 365 • Cash Conversion Cycle = DIO + DSO − DPO Indian banks: capital adequacy ratio (CRAR) ≥ 11.5% for scheduled banks under Basel III.

Advanced

Subtle: book value of equity ≠ market value. Most assets at historical cost. • Asset-heavy companies (steel, real estate): book often understates market value • Asset-light (software, services): book understates true value (intangible capital not capitalised) P/B ratios by sector: • Banks: 1-3× book • Software/services: 5-15× • Brands (FMCG): 3-8× Forensic FSA: focus on ratio trends. • Rising AR/Sales ratio (DSO climbing): customers stretching, demand softening, or aggressive recognition • Rising Inventory/Sales ratio (DIO climbing): demand falling, obsolescence risk • Falling DPO: supplier stress • Rising debt-to-equity: leverage strategy or distress Indian conglomerates often complex — multi-layer subsidiaries, related-party transactions. Adjust for fair-value treatment of holdings.

Regulatory references
  • IFRS / Ind-AS standards
  • CFA Institute curriculum
  • Basel III for banks
Common mistakes & pitfalls
  • Comparing ROE without DuPont decomposition.
  • Using book value as market value.
  • Ignoring sector-specific ratios.
  • Surface-level liquidity assessment.

Frequently asked

Why does HDFC Bank have lower margin than TCS?
Bank net margin is "income/total revenue" but bank revenue includes interest expense as gross. Operating margin comparable to other banks; net margin different concept. Use NIM (Net Interest Margin) for banks, not generic.
Is high D/E always bad?
No. Capital-intensive businesses (banks, infrastructure) need leverage. Light-asset businesses (software) typically don't. Industry-relative D/E is meaningful.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
DuPont ROE formula:
  1. (a)Sales × Profit
  2. (b)Net Margin × Asset Turnover × Leverage
  3. (c)Equity ÷ Net Income
  4. (d)Just ROE = NI/Equity
Correct: (b) Net Margin × Asset Turnover × Leverage
DuPont: ROE = Net Margin × Asset Turnover × Leverage. Decomposes ROE into 3 drivers. 5-step adds tax and interest burden.
Q 2
Cash Conversion Cycle = ?
  1. (a)DIO − DSO
  2. (b)DSO + DIO − DPO
  3. (c)DPO − DSO
  4. (d)DSO + DPO
Correct: (b) DSO + DIO − DPO
CCC = DSO + DIO − DPO. Measures days from cash outflow (paying suppliers) to cash inflow (collecting from customers). Lower is better.
Q 3
Quick Ratio:
  1. (a)CA / CL
  2. (b)(CA − Inventory) / CL
  3. (c)Cash / CL
  4. (d)Sales / CL
Correct: (b) (CA − Inventory) / CL
Quick = (Current Assets − Inventory) / Current Liabilities. Removes less liquid inventory.
Q 4
Bank capital adequacy under Basel III:
  1. (a)Optional
  2. (b)Minimum CRAR ≥ 11.5% for scheduled banks
  3. (c)Always 100%
  4. (d)Set by individual banks
Correct: (b) Minimum CRAR ≥ 11.5% for scheduled banks
Basel III: minimum CRAR 11.5% for scheduled commercial banks in India. Higher than Basel II.
Q 5
P/B ratio is most useful for:
  1. (a)Software companies (intangibles)
  2. (b)Banks and asset-heavy companies (book reflects value)
  3. (c)Consumer goods
  4. (d)No use
Correct: (b) Banks and asset-heavy companies (book reflects value)
P/B works for banks (book reflects value reasonably) and asset-heavy. Less useful for software (intangibles excluded from book).
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.