People in current markets are inclined towards making profits and increasing their earnings. They want to invest in sectors and companies that are at their booming phase and would probably provide them with the highest returns.
But how are their investment decisions made by their individuals? On what grounds do they decide whether they should invest in one particular company or another?
These decisions are made by referring to the financial statements of the company and studying their growth pattern over the years. Financial statements such as Balance Sheet, Profit, and Loss accounts, Cash Flow Statements, etc. reflect the position of the company in terms of profitability and liquidity. It tells us where the company has made its investments and how much reserves it has created by now and how much money does it need to run its business on a daily basis and the kind of liquidity it has.
Now, let us go through the 5 components of the balance sheet that influence the investment decisions of the investors:
Debt funds are seen under borrowed funds or long term borrowings section in the balance sheet. These are the funds that a firm borrows from banks, financial institutions or any other sources for a fixed period of time which is more than a year at a fixed rate of interest which is to be paid at the time of repayment.
It is usually interpreted that if the company has borrowed a considerable amount of fund which needs to be refunded at a specified future date, the risk of investing in such an organization can be high. However, if the amount of borrowed funds is less, it may be safe on the part of the investor.
Free reserves are created for any contingencies which may arise at any point in time for which the firm might have to withdraw funds. It could also be used for investments. The company might even decide to declare dividends, issue bonus shares, write accumulated losses from such reserves.
The amount of free reserves that a company has accumulated is directly related to the kind of liquidity position the firm has over a period of time.
If these free reserves are not used for paying dividends or declaring a bonus, then they might be utilized into making new investments in Plant and Machinery or other profitable projects which will bring in better efficiency and profits for the company and hence better returns for the people who have invested in the firm.
Investments are the areas or instruments wherein a company invests its idle money with the aim of either getting higher returns or for the purpose of growth. They can be for a short period that is, for a year or for a long term which may range from 3 to 5 years or even more.
The investments of the firm indicate the inclination of the company in different sectors and is a key to judging whether it is planning to grow or even diversify its business sometime.
Contingent liabilities refer to the liabilities which may or may not arise in the future and depends on the happening of a particular specified event. It a liability or provision created for a potential loss that the company might have to bear. For example product warranties, expenses on pending investigations, potential lawsuits, etc.
Usually, companies maintain a separate account under the notes to financial statements for such contingent liability expenses which may arise. The main idea of it is to not disturb the normal operations of the business and meet such obligations smoothly.
The capital required to carry out the day to day operations of the business is referred to as the working capital. It is the net current assets that the company has after subtracting current liabilities of the firm which is needed to repay.
The liquidity of any company is related to net current assets it has that is, the working capital of the firm should always suffice the operating expenses of the firm or else it might have to undergo liquidation.
Therefore the working capital should always be either enough to cover the expenses or more than what is required to be on the safer side.
An investor should minutely examine the above components of the balance sheet while investing in a company, however, he might want to add other components as well for a better judgment which is a sign of a cautious investor and is absolutely fair and appropriate.