If reading the numbers on a corporate balance sheet was sufficient research to determine the viability of a company as an investment, every investor would be wealthy. However, the financial numbers only indicate if further research is warranted. There are a variety of other factors to consider for an investment in addition to fundamental ratios.
Be sure to ask yourself these 8 important questions before investing your money:
1. How much cash does the company have?
Healthy cash reserves can help a company weather short-term turbulence. Having little cash on hand does not leave enough of a cushion to absorb financial setbacks. In addition to cash balance, consider how much money the company owes its creditors.
2. Does the company have a competitive advantage, also known as a wide economic moat?
Coca-Cola has an established worldwide brand based on their secret soda recipe. Drug companies often own patents on important medicines, granting them a short-term monopoly. Ask yourself what key advantage does the company you want to invest in possess?
3. Is the company profitable?
Companies that use leverage during a rapid growth phase can fail to turn a profit for several years and still be lucrative investments, yet instances of this are rare. Any company with growing profits, however, will enjoy an increase in share price eventually. Know whether profits are increasing or decreasing.
4. How good is the management team?
A struggling company with great management can turn things around. A profitable company with poor management can take a nosedive in a hurry. You need to learn as much as you can about the track record of the current management team as well as any changes that might take place in the near future, for better or for worse.
5. Is the company stagnating?
Overconfident companies with little competition can become complacent and make poor financial decisions. Ideally, a company should only spend money that will make them a return on their investment. Complacent companies often spend money on items that don’t add to the bottom line.
6. What is the future of the industry?
Operating brick-and-mortar video rental stores might have been a good investment 30 years ago, but with the advent of online video streaming, the business model died out quickly over the course of just a few years. Does technology or a change in consumer sentiment offer significant headwinds to your investment?
7. Is there room for growth?
Small companies generally have more growth opportunities than larger ones. What about the industry? Is it expanding or contracting?
8. Who is the competition?
Do any competitors have a significant advantage? Maybe there are no significant competitors which can be a good thing. Like deciding whether to bet on your favorite football team, it is always a mistake not to consider the quality of the opposition. If you only looked at the team that you love, you’d never bet against them. Do the same with your investments.
It is important to weigh investing decisions carefully. Most people spend more time researching a vacation than our investments. An investment should not be akin to purchasing a lottery ticket. Your decision should be based upon careful research. While planning a trip to Hawaii might be more interesting, a few wise investments can pay for a lifetime of tropical vacations.
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