Investment and Opportunity Cost (Part II): Understanding the Balance Sheet

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Sequel to Part 1, financial statements basically serve as signposts guiding investors along the investment path. Information extracted from them may either give you the green light to invest, red light not to, or yellow light to wait and observe future outcomes.

Any investor who enters into a financial contract wants to cash in without disappointments. So you should focus your attention on what and where you invest in, rather than just investing.

Fight the temptation of leaving it all for the analyst to decide where your money goes. That sounds like getting on a plane without being able to decide your destination. Agreed, that’s what he might be trained to do, but it’s your money and you should be able to have a say.

So if you choose to lend at any time, here are quick deductions you can make from a borrower’s balance sheet to help you make a better judgement before investing.

For short-term investments;

Keep an eye on the borrower’s liquidity. From the borrower’s perspective, liquidity is the ability to meet short-term obligations.

Certain ratios calculated from balance sheet items can be used to determine a firm’s ability to pay its short-term liabilities. Such ratios are employed by investors for better decision making. Below are a few key ratios.

#1. Current Ratio

This is the best known measure of liquidity. A high current ratio just means you are likely to receive your returns in a timely manner because the firm will have no difficulties paying its short-term bills.

High Current Ratio = ü (Green Light)

Low Current Ratio = û (Red Light)

#2. Cash Ratio

From the name you can already tell what to look out for. Who wouldn’t agree that high levels of cash are a good sign? So the higher the cash ratio, the more likely it is that the borrower will be able to meet short-term obligations without hassles.

High Cash Ratio = ü (Green Light)

Low Cash Ratio = û (Red Light)

For Long-term investments;

If you choose to invest for a longer period, then you should look out for good solvency attributes. Solvency is the ability of a firm to meet long term obligations. So here are a few ratios that measure solvency.

#1. Debt-to-Assets Ratio

An increase in this ratio suggests a high reliance on debt as a source of financing. High reliance on debt means that the company has many short and long term obligations to meet and this may affect its solvency.

High Debt-to-Assets Ratio = û (Red Light)

Lower Debt-to-Assets Ratio =  ü (Green Light)

#2. Financial Leverage Ratio

High use of debt financing increases financial leverage and, typically, risk to investors.

High Financial Leverage Ratio = û (Red Light)

Lower Financial Leverage Ratio =  ü (Green Light)

Formulas

Current Ratio = current assets  ⁄ current liabilities

Cash Ratio = cash+marketable securities  ⁄ current liabilities

Debt-to-Asset Ratio = total debt ⁄ total assets

Financial Leverage Ratio = average total assets ⁄ average total equity