- The ability and consistency of a business to pay dividends is seen as one of the essential indicators while investing.
- There are far more indicators of a business performance other than dividend yields, like the balance sheet and cash flow statement.
- Balance sheet helps to ascertain the financial wellbeing of the business, while the cash flow statement helps to ascertain the cash inflows, outflows, and source of generating cash for the business.
If you ask an investor what he/she looks for in a business before considering investing in it, a lot of them would readily respond with dividend yields. Specifically, the investors looking to develop another source of income are ready to snap up dividend-paying stocks.
So, are dividend yields the only thing worth looking at?
No, absolutely not
An investor might look at several other indicators that may shed light on the performance of a business. However, different indicators reflect different types of performance. For example, dividend yield and total return describe various aspects of stock performance over a certain time period.
Before looking at other financial indicators, let us talk about dividends and dividend yield.
Clearly stating- dividends are a part of the profits of a company that are distributed to the shareholders. Needless to say, dividends paid by the company indicate financially healthy business and boost the confidence of an investor in the business.
Dividends are a compelling indicator for long-term investors looking for an income stream. Moreover, dividends can be reinvested, and the investor can choose to buy more shares.
But here is the catch.
Considering only dividend yields can cost a pretty penny for the investor. Businesses continue to pay dividends even when they earn low profits or undergo short-term losses. More importantly, several businesses pay aggressive dividends in and later find lesser profits available for reinvesting to prolong their operations on the road ahead.
However, a well-researched investment option with a thorough understanding of the business fundamentals and financials can help to make a more informed decision.
Therefore, there is a lot more to look at beyond dividend yields.
We shall now talk about some indicators that offer a clearer picture of a business financial soundness.
A vital financial statement that ought to be interpreted while considering investing in a business is the balance sheet of a business as it is a statement of assets and liabilities owed by the business at a given point of time.
Short-term liquidity, asset performance, and capitalization structure are some of the investment-quality measurements that help to evaluate the strength of a company's balance sheet. The capital structure comprises debt and equity component of a business on its balance sheet.
Working capital or the cash conversion cycle can be calculated as the excess of current assets over current liabilities. Current assets, as well as current liabilities, are usually on the books for less than one year, meaning they are short-term in nature.
The cash conversion cycle indicates how well the business manages its most important current assets, namely, inventory and accounts receivable.
An investor can look for cash conversion cycle of a business over an extended period of time and compare it with that of the competitor before deciding to invest in a stock.
Another element that can be identified from the balance sheet of a company is the fixed asset turnover ratio over several periods, as the businesses are likely to update and add new equipment over time.
Moreover, inventory, receivables, intangibles, and property, plant and equipment are some of the key accounts on the asset side of a balance sheet to look. Efficient management of these significant asset types helps to build a strong balance sheet.
Cash Flow Statement
Cash flow statement is a statement that shows cash inflows and outflows of a business over a period of time. Moreover, it highlights the cash and cash equivalent of the company.
A lot of times, people may confuse the earnings of the business with the cash available. The cash flow records the transactions of the business where the cash (whether incoming or outgoing) is the prime substance to complete a deal. It ultimately calculates the change in the cash balance of the business.
Cash flow statement is a precise determination of the cash a business is generating from various types of activities, operating, investing, and financing as they affect the cash position of the business. Cash flow statement is also an essential medium to understand whether a company have chances to fail. The businesses that neglect to ascertain and maintain correct cash in hand to pay bills have fair probabilities of failing.
Avoiding Complex Investment
However, an investor can be good at understanding and interpreting the financial information of a business, yet there lies an important point to consider before investing, which is the understanding of the business.
As said by Warren Buffett:
“Never invest in a business you cannot understand”
Investing in a business without developing understanding and clarity about business fundamentals and its revenue model might lead to failed investment and poor decision making in times of opportunity as well as market uncertainties.
Dividend yield can be said as an important indicator for the investors who are looking for investments to provide consistent income over the period. However, an investor’s evaluation of a potential investment should not be limited to the dividend yield. As there are far more exciting aspects about investing in stocks, an investor should be willing to consider further indicators like balance sheet and cash flows along with adequate research.