Why you should read the balance sheet before investing

Let’s do a quick thought experiment.

Imagine that you wake up in a faraway land where people do not speak English or any other language that you are familiar with. You have to live there for the rest of your life. Can you increase the odds of your survival and prosperity by learning the local language of that place?

If your answer is yes, then you will be convinced of the importance of reading a balance sheet before investing.

Businesses exist to make money. Investors exist to make money from money. Investors put their money in businesses so that they can be proportionately benefitted from the wealth that those businesses create over time. So, as an investor, the ability to assess the health of a company is a must to succeed. To understand how a company is doing, you need to understand the nature of the business and its performance in quantifiable terms. The best finance courses enable you to do just that.

The story of how a business is doing in quantifiable terms is written in the language of “accounting”. Does the word accounting conjure up the image of diligent (and tedious) recording of all the financial data in the books? Before you let that feeling overwhelm you, let me clarify that the kind of accounting you need to learn is vastly different. You need a very high-level analytical view of the business to understand the business performance. Accounting is done by the bookkeepers within a company. The books are then used to prepare financial statements. Your investment decisions will be based on the analysis of these financial statements.

Now, let’s demystify financial statements.

What are financial statements?

Financial statements are a set of reports that give an accurate and quantifiable picture of the well-being of the company in a given time frame. Chiefly, there are four kinds of financial statements that are prepared by a company’s management. They are

  • Balance Sheet: This reports the number of assets, liabilities and stockholder equity at a given time in the company
  • Income Statement: This reports the earning of the company in a given accounting period. Earning/Income = Revenue – Expenses
  • Statement of Cash Flows: This statement reports the details the inflow and outflow of cash in a company. The cash inflow and outflows are reported under the heads of operating, investing and financing activities
  • Statement of Retained Earnings: This report captures the change in the financial position of a company due to income and dividend distribution in an accounting period

These four statements give a reasonably accurate picture of how the company has performed in a particular time period.

Now, coming to the analysis of balance sheet- this is the analysis you should be doing before investing. In non-financial terms, you can consider balance sheet as a photograph of a company. It gives the picture of the financial condition of the company at a particular instant.

[Diagram of Balance sheet]
Left side: Assets
Right side: Liability and Shareholder’s Equity
balance sheet format

In a single report, the balance sheet format gives a representation of what company owns (Assets), What it owes (Liabilities) and the worth of the shareowners of the company. The basic accounting equation defines this relation as follows:

Assets = Liabilities + Shareholder’s Equity

On a close look, reading a balance sheet gives out a plethora of information that can help you decide on your investing decision. To list out a few:

  • The working capital requirement of the business
  • Adequacy of the working capital
  • Asset turnover, i.e. how efficiently a company uses its assets to make a profit
  • Cash conversion cycle, i.e. how quickly the company completes its inventory turnover
  • Short and long-term loans of the company
  • A measure of intangible assets and its impact on the financial health
  • A measure of the tangible net worth of the company
  • How much credit a company is extending to the customers and whether it is within safe levels

A careful analysis will not only show you what is apparent, but it will enable you to read between the lines and understand what might be obfuscated to an untrained eye.

To help you do that we recommend one of the best finance courses in India led by Dr. Anil Lamba. He is a bestselling author, financial literacy activist, and a corporate trainer of international repute. This short-term course in finance on “Good Finance Management” will equip you to take confident strides in the area of investing.

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