Why is the short-term liquidity important?

This shock can cause a shortage of sales, supply-chain problems or a significant increase in imputs (and energy), which can significantly affect the company’s sales. If a company does not have enough TCA and interest rates are high, it must secure additional short-term financing (cheaper) or long-term financing (more expensive). If TCA <TCL, it could be difficult for a company to borrow for short-term debt (in the open market or via bank financing), it may endanger its financial health, increasing the chance of default. 

Again, long-term financing postpones this problem; debt repayments are spread over a more extended period but are more expensive. The company you invest in must have a solid balance sheet. Even if it does not go bankrupt (which is the Worst case scenario), the debt leverage increases that probability and further reluctance to indebted the company. From this point of view, the company will reduce its investments (CAPEX) in the long run, which may harm its growth. 

Namely, the company free CF does not invest in further development but just to repay the old debt. Of course, this is not always the case. In the short term, the company may have a TCA <TCL relationship, e.g., if the macroeconomic environment is suitable for lending or the overall economic situation in the country is favorable. But in the long run, there may be a problem, as is currently the case in China in the real estate sector. There, the prices of some development companies fell by more than 70%.

The structure of the assets is also very important. Now we mean the long-term ones, such as land, property, etc. It´s called PP&E (Property, plants and equipment). Some asset components may be artificially inflated and distort the overall balance sheet. Don’t just look at long-term assets, even if you should compare them with long-term liabilities.

However, in the short term, a company may sell its assets below book value to cover its liabilities or make a dilution or bond issuance (both harm the stockholder). Again, this is especially true if company does not have enough TCA to cover TCL. We will talk much more in the detailed chapter, which will focus on the balance sheet analysis. The point is that some “hints” are valid for balance sheet analysis in general, but each company is individual and specific and should be analyzed separately. What applies to one may not fully apply to another. What applies to one sector may not apply precisely to another industry. It depends on the industry, core business, the business model and strategy of the company.