Balance sheet and investment choices-Using Owners Equity

How can balance sheet be useful in investment selection?

Balance sheet is a reliable tool to guide an entrepreneur or a businessperson to choose the right investment

Balance sheet format

Scenario : Using Owners Equity (Owner’s contribution) as Source of Capital

If an entrepreneur has to inject his or her cash savings of $100,000, then he/she need to consider opportunity cost of the same amount. Opportunity cost is the monetary value of the next best alternative foregone.

Steps of choosing the right investment

Step One: Identify a variety of Business Opportunities

Carry out an investment market survey to identify different business opportunities. For example, assume you have identified;

Investment one-3% per annum returns, with $100,000 initial outlay

Investment two-10% per annum returns, with $100,000 initial outlay

Investment three-15% per annum returns, with $100,000 initial outlay

Step Two: Select the most competitive investment opportunity

The best alternative selected will be pegged on the level of risk. The more the return the more the risk and vice versa is true. So based on your risk appetite, you can choose any of the above three investment opportunities

Step Three: Benchmark selected investment with prevailing opportunity cost

Consider the opportunity cost of investing in the three options above in respect to keeping cash (idle money) under the pillow.

Step Four: Select the most suitable Investment

The most suitable investment is relative for it depends on the investor’s risk appetite. Therefore, the three investment options are appropriate for they are better as compared with idle money with zero returns.

Illustration

Whitney is a new investor in the market and has $20,000 available to venture in business. She has identified the following business opportunities

Opportunity one-12% per annum

Opportunity two-7% per annum

Opportunity three-16% per annum

Opportunity four-22% per annum

NB: All the investment opportunities had the same initial capital outlay of $20,000

Required analyze the best investment Whitney should select or invest in

Solution

Step one;

The available opportunities are

Opportunity one-12% per annum

Opportunity two-7% per annum

Opportunity three-16% per annum

Opportunity four-22% per annum

Step two;

Any of the opportunities is appropriate for we are to compare the returns of the investment and the option of not investing (ie remain with the idle cash).

That is before any investment is done, the financial position of the potential investor represented by the balance sheet below is A=$20,000. But the nature of the asset (i.e cash) is referred to as idle money and it is a non-interest earning asset for at the end of a specific period, the returns are zero.

Balance sheet format

The opportunity cost of investing in Opportunity one-12% per annum is ZERO.

This means that it is cheap to invest in an opportunity with returns of 12% per annum for the lost benefit of not investing anyway (keeping idle cash in the house) is 0% returns. So Whitney is losing nothing

NB: That if Whitney chose to keep idle cash, she will get 0% returns and forgo a 12% returns from the 12% per annum investment opportunity. This would be very costly.