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¶ … balance sheet is a good way to gauge the health of a company's finances. However, I have found that financial statements must always be taken into context, and the context is not always apparent. Firms in different types of industries, for example, will naturally have balance sheets that look different, the most glaring example being financial institutions.
The balance sheet is also a snapshot, which can be frustrating. This means that if the firm makes a significant change, it will not be reflected right away in the financial statements. This means that the balance sheet may not accurately reflect the firm's current situation. Similarly, the balance sheet can become skewed by major transactions. A firm can take on a significant amount of debt for an acquisition, leaving it with a poor balance sheet for a year or two. However, the long-term implications of the acquisition might be very positive.
Working with the balance sheet means taking a wide range of factors into consideration. Liquidity ratios can be valid, but only in context with industry norms, and even then they are best also taken into context of the firm's operations. Capital structure decisions can be deliberate as well, yet an analyst without knowledge of the firm's intentions could make an entirely different determination about the validity of the firm's capital structure if based only on the balance sheet. At a minimum, the income statement is also required and in most cases much more information than that is needed to make an accurate assessment of the firm's financial condition (Kennon, 2010).
Essentially, the balance sheet is a useful tool for analysis, but it must be taken into context with a wide variety of other information, not all of which will be in the notes. In that regard, financial statements are limited and the analyst is recommended to consider those limitations when undertaking an analysis of the balance sheet.
Works Cited:
Kennon, J. (2010). What the balance sheet can and cannot tell you. About.com. Retrieved January 28, 2010 from http://beginnersinvest.about.com/od/analyzingabalancesheet/a/putting-together-balance-sheet.htm
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