Most important balance sheet KPI

Question

Hi, I‘m prepping for an interview which is potentially heavy on balance sheet know how.

Rumors are that candidates will be asked: „If you could only choose one balance sheet KPI to determine whether or not the firm does ‚good‘ or ‚bad‘, which one would it be and why?“

Any thoughts on that?

Personally, I’d go for the EVA...

Answer 1

Hi Anonymous!

to be honest - this can not be answered in a general way, since it heavily depends on the industry (e.g., banking balance sheets are completely different from mining company balance sheets), and also on the company-specific situation (e.g., whether liquidity/solvency is a major concern in the current lifecycle stage).

Here are a couple of examples, but there may be many more, contingent on the actual context:

Solvency Ratios

Quick Ratio = (Current Assets – Inventories) / Current Liabilities: the quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.
Current Ratio = Current Assets / Current Liabilities: an even simpler variant to the quick ratio and is used to determine the company’s ability to pay back its short term liabilities. If the ratio is below 1, it raises a warning sign as to whether the company is able to pay its short term obligations when due. It doesn’t mean the company will go bankrupt, but is something that has to be looked at. If a company has a low current ratio year after year, it could be a characteristic of the industry where companies operate and high debt levels.

Debt/Equity Ratios

Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity: the objective of this KPI is to determine how a company has been financing its growth. A high ratio means that the company has been growing due to debt. Not all debt is bad, but if the number is exceedingly high, remember that the company has to pay off the loan as well as interest payments. An important factor to consider then is to determine whether the returns generated from the debt exceeds the cost of debt (i.e. interest).

Turnover Ratios

Receivables Turnover = Revenue / Average Accounts Receivables: the receivables turnover ratio is one that is categorized as an activity ratio because it measures the company’s effectiveness in collecting its credit sales.

Inventory Turnover = COGS / Average of Inventory: Inventory is money. It costs money to buy, it costs money to just hold it because it takes up a lot of overhead if it isn’t cleared out. You waste shelf space, the product gets old and it may have to be sold at a fraction of the price just to get rid of it. Inventory turnover is important for companies with physical products and is best used to compare against peers. After all, the inventory turnover for a retailer like Wal-Mart is going to be very different to a car company like Ford.

Cheers, Sidi

Answer 2

Hi Sidi,

thank your for your reply. Well, I think what you are stating in your intro goes without saying and it might be useful to state that in the interview for the sake of completeness.

However, if the interviewer insist that you choose one KPI/ratio only, without clarification on the industry, the goal, whatsoever, which one would you (or the community) pick?

Again, I think the EVA is one of the KPIs that you could justify, as it takes into account the regular business activities/operations (via NOPAT) and accounts for the capital structure to a certain extent. One might even go as far and state, that it includes measures of productivity.

Happy to discuss further!