Balance Sheet- The statement of financial position

What is a balance sheet? A balance sheet is a quantitative summary that shows a company’s financial position at a given point in time. This includes the company’s assets, liabilities and net worth. So, what do you need to pay attention to when looking at a balance sheet? Well, we can summarise it with one word: liquidity.

Liquidity reflects the degree to which a company can repay its short-term debts and obligations on time. In principle, a wise investor finds it safer to invest in liquid assets because it is easier to get one’s money out of the investment. So, how do you measure a company’s liquidity? A company’s liquidity status is often reflected by its current ratio and cash ratio. If these are not available, a simple comparison of the company’s cash, current assets and current liabilities will do the job. If the company you are investing in shows low liquidity, then you have to think twice about keeping your investment. There are exemptions, however, when one considers a company’s business model, cash generation ability and sustainability. Telecommunications companies, for example, have weak liquidity ratios at first glance, but compensate for the manner in which they tie down their customer base. And depending on the basis of investing in the business, it may be good to have an asset light balance sheet.

For most investors, the reason to invest in a business is for its profits and cash flow, not so much of its assets. This is because the assets in the business kind of  act like collaterals. Also, do take note of the risks involving debt in the company by looking at debt to income ratio, and debt to equity ratio. This will also vary, though, depending on the industry and the business model. In any case, the key questions to ask are, whether the debt is easily serviceable, and whether the company has enough reserves to meet possible contingencies in the event of a crisis.

Remember, all investments have risks, but they can be minimised with the right knowledge.

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