Optimizing your investment portfolio for long-term growth

Fact checked by Katrina Munichiello
Reviewed by Pamela Rodriguez

Rebalancing is an essential part of managing your portfolio. As the market moves, it causes the relative weights of different assets in your portfolio to shift. Rebalancing allows you to maintain your target asset allocation and address any risks.

However, not all rebalancing strategies are created equal. Each approach has varying levels of precision, cost-efficiency, and potential returns. Below, we’ll explore the main portfolio rebalancing strategies. From calendar-based methods to threshold-driven techniques, understanding these approaches can help you develop an approach that best fits your investment goals, risk tolerance, and trading style.

Key Takeaways

• Portfolio rebalancing provides protection and discipline for any investment management strategy at the retail and professional levels.
• Rebalancing enables investors to ensure that their portfolio remains aligned with their intended risk profile.
• Strategies include calendar rebalancing, percentage-of-portfolio rebalancing, and constant-proportion portfolio insurance.
• The algorithmic rebalancing approach uses robo-advisors to continuously monitor and adjust portfolios. It offers precision and efficiency but may lack the human touch in considering broader financial goals.

Why Rebalance?

Portfolio rebalancing keeps your holdings from being overly exposed to unexpected risks and ensures that its assets are within the manager’s expertise. This manager could be your financial advisor or you.

Suppose a retiree has 75% of their portfolio invested in risk-free assets like U.S. Treasuries, with the rest in equities. If the equity investments triple in value, 50% of the portfolio would now be allocated to stocks on the risky end of the risk/reward scale.

An individual portfolio manager specializing in fixed-income investments would no longer be qualified to manage the portfolio since the allocation has shifted outside their area of expertise. In addition, the growing proportion allocated to equities increases the overall risk to levels beyond those that retirees typically want.

To avoid these unwanted shifts, the portfolio must be regularly rebalanced. These are among the reasons you should periodically rebalance your portfolio:

1. Keeping your target asset allocation: As we’ve noted, market shifts cause the relative weights of different assets in your portfolio to change. Rebalancing helps maintain your target asset mix, ensuring your portfolio aligns with your risk tolerance and investment goals.
2. Managing risk: As certain assets outperform others, your portfolio can become riskier than intended. For instance, in the example above, when equities significantly outperformed bonds, the portfolio became overexposed to stock market risk. Regular rebalancing helps manage this risk by bringing your asset allocation back in line with your risk tolerance.
3. Part of disciplined investing: Rebalancing helps enforce a “buy low, sell high” discipline. It encourages you to sell assets that have appreciated and buy those that have underperformed, potentially improving long-term returns.
4. Helping with emotional neutrality: Markets can trigger emotional responses that lead to poor investment decisions. A systematic rebalancing approach helps remove emotion from the equation.
5. Improving performance: Regularly rebalanced portfolios can outperform those left to drift with market movements over the long term. This is partly because of the reduction in portfolio volatility and the harvesting of gains from high-performing assets.
6. Adapting to changing circumstances: As your life circumstances and financial goals evolve, rebalancing is a good time to adjust your portfolio accordingly. For example, as you near retirement, you might rebalance to a more conservative asset mix.
7. Managing your taxes: In taxable accounts, rebalancing can be used strategically to lower your tax bill. For instance, you can time rebalancing to harvest tax losses or to coincide with more favorable tax treatments.

Asset Correlations and Rebalancing Your Portfolio

Before getting into the different rebalancing strategies, another essential element to highlight is the need to track the correlations among the assets in your portfolio. Correlation is the degree to which two assets move in relation to each other.

It ranges from -1 (perfectly negative correlation: when one goes up, the other goes down, and vice versa) to +1 (perfectly positive correlation: they both move in sync), with 0 indicating no correlation.

Below is a correlation table that gives you a comparison of the returns for common investment assets. The exchange-traded funds (ETFs) listed are to be used as proxies for the asset classes they hold:

Here are some of the more important points about portfolio correlations:

• Diversification: Assets with low or negative correlations can help reduce overall portfolio risk. When one asset declines, the other may remain stable or increase, offsetting losses.
• Correlations shift: Correlations aren’t static and can change over time, especially during market volatility when many assets may become more correlated.
• Asset allocation: Understanding correlations helps in constructing more efficient portfolios. Combining assets with low correlations can help improve risk-adjusted returns.
• Managing risk: By including assets with diverging correlations, you can better handle volatility and downside risk within your portfolio.

While useful, correlation doesn’t capture all aspects of the relationship between assets. In addition, it doesn’t imply causation and may not reflect other relationships between the asset types.

Note

Avoid checking on your investment values too frequently (daily or weekly). This can lead to a sense that you need to act, which typically leads to overtrading and fewer investment returns. 

Prominent Approaches to Rebalancing Your Portfolio

There are several basic rebalancing options that either retail or institutional investors often use to improve their returns and manage risk.

Calendar Rebalancing

Calendar rebalancing is the simplest rebalancing approach. This strategy involves analyzing the portfolio’s investment holdings at preset intervals and adjusting to the original allocation at a desired frequency.

Experts generally advise assessing your portfolio quarterly or yearly. Weekly rebalancing would be overly expensive in taxable gains and other transaction costs, while waiting more than a year would mean there’s too much time for portfolio drift.

How often you rebalance your portfolio should be based on your time, the costs of reallocating it, and the allowable drift of your holdings.

A significant advantage of calendar rebalancing over formulaic rebalancing is that it is significantly less time-consuming for the investor since the latter method is ongoing.

Percentage-of-Portfolio Rebalancing

Also known as tolerance band rebalancing or corridor rebalancing, this approach requires more work but is worthwhile and involves a rebalancing schedule focused on maintaining acceptable, preset percentages of assets in your portfolio. Every asset class or individual security is given a target weight and a corresponding tolerance range.

For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips, and 40% in government bonds with a margin of plus or minus 5% for each asset class.

Thus, emerging market and domestic blue chip holdings can fluctuate between 25% and 35%, while 35% to 45% of the portfolio must be allocated to government bonds. When the weight of a holding jumps outside the allowable band, the entire portfolio is rebalanced to reflect the initial target allocation.

Important

The calendar and corridor rebalancing methods are known as constant-mix strategies because the weights of the holdings do not change.

Setting the range of your corridors (the “width” you allow for each kind of asset) depends on the characteristics of individual asset classes since different securities possess unique properties that influence the decision.

Transaction costs, price volatility, and correlation with other portfolio holdings are the three most important variables in determining band sizes. Intuitively, higher transaction costs require wider allowable ranges to decrease the impact of expensive trading costs.

High volatility, meanwhile, has the opposite impact on the optimal corridor bands—riskier securities should be confined to a narrow range to ensure that they are not overrepresented or underrepresented in the portfolio.

Finally, securities or asset classes strongly correlated with other held investments can have broader ranges since their prices move in line with others in the portfolio.

Constant Proportion Portfolio Insurance

A third rebalancing approach, the constant proportion portfolio insurance (CPPI) strategy, assumes that as investors’ wealth increases, so does their risk tolerance. As such, this approach keeps a minimum of safety reserves held in either cash or risk-free government bonds.

CPPI aims to protect the portfolio from a drop in asset values while allowing investors to benefit from market gains. This makes it particularly attractive to those who want to limit potential losses but aren’t willing to entirely forgo the chance for higher returns.

The strategy begins by dividing a portfolio between two main segments: a risky asset, typically stocks or stock indexes, and a risk-free asset, such as cash or short-term government bonds. What sets CPPI apart is its use of a preset “floor” value—the minimum acceptable portfolio value that an investor is willing to tolerate. The difference between the present portfolio value and this floor is called the cushion, which drives the strategy’s allocations.

CPPI employs a multiplier, applied to the cushion, to determine how much of the portfolio should be invested in the risky asset. As the portfolio value increases, creating a larger cushion, the strategy automatically shifts funds into the risky asset to capitalize on market growth.

Meanwhile, when the portfolio value declines and the cushion shrinks, CPPI calls on you to reduce your exposure to risky assets, moving more into the safety of the risk-free asset. In the extreme scenario where the portfolio value hits the floor, the entire portfolio would be shifted into money or risk-free bonds to prevent further losses.

The choice of the multiplier is central. Typically, multipliers range from three to six but can be higher or lower depending on the specific circumstances. For example, a multiplier of four would mean that for every $1 of cushion, $4 would be invested in the risky asset. Some things to consider:

• What is your risk tolerance? The multiplier is primarily chosen based on the investor’s risk tolerance. A higher multiplier increases potential returns but also increases risk, while a lower multiplier provides more protection but may limit upside potential.
• Is the market going through stress? The expected volatility of the risky asset should be considered. A lower multiplier might be chosen in highly volatile markets to provide more stability.
• How long is your investment horizon? Longer investment periods can generally accommodate higher multipliers as there’s more time to recover from downturns.
• How often will you be rebalancing? Higher multipliers generally lead to more frequent rebalancing.

When using CPPI for rebalancing your portfolio, the amount of money invested in stocks can be determined with the following formula:

$begin{aligned} &$text{ Stock Investments} = M times (TA – F)\ &textbf{where:}\ &M=text{Investment multiplier (More Risk = Higher }M)\ &TA=text{Total portfolio assets}\ &F=text{Allowable floor (minimum safety reserve)}\ end{aligned}$​$ Stock Investments=M×(TA−F)where:M=Investment multiplier (More Risk = Higher M)TA=Total portfolio assetsF=Allowable floor (minimum safety reserve)​

For example, suppose you have an investment portfolio of $300,000, of which $150,000 must be saved to pay for your child’s university tuition. The investment multiplier is 1.5.

Initially, the funds invested in stocks are $225,000 (1.5 × [$300,000 – $150,000]), with the remainder in risk-free securities. If the market falls by 20%, then the value of the equity holdings will be reduced to $180,000 ($225,000 × 0.8), producing a total portfolio value of $255,000 (the worth of the fixed-income holdings remains at $75,000).

You would then need to rebalance the portfolio using the previous formula. As such, only $157,500 would now be allocated to risky investments: 1.5 × ($255,000 – $150,000).

This approach shouldn’t be used on its own since it doesn’t address which assets and other strategic decisions are essential to any rebalancing process.

Pros

• Provides downside protection

• Allows exposure to market upswings

• Automatically adjusts risk exposure based on market conditions

Cons

• Can lead to high turnover

• May underperform in volatile, sideways markets

• Risk of being locked into cash if the portfolio value hits the floor

What to Consider When Choosing a Rebalancing Strategy

There are various factors to consider when rebalancing. You’ll need to settle on an asset allocation target based on your investment goals, time frame, and risk tolerance while figuring out how much leeway you’ll give to allocation changes before stepping in. After that, you can come up with a suitable rebalancing schedule.

There isn’t a specific frequency that is better. The general rule is to strike a balance between not leaving it too long so the portfolio’s asset allocation drifts too far out of sync and not too frequently so that you’re paying too much in taxes and transaction costs. Some pundits believe one year is the ideal time frame.

Generally, a good rule is to settle on a strategy beforehand and then rigorously stick to it. Periodic revisions are OK and healthy. However, you want to make sure you don’t panic in the middle of a bear market or get too greedy and lose the sense of risk in a bull market. Changes to strategy should be taken calmly and with careful consideration, ideally with the help of a professional.

 Vanguard recommends three best practices for executing a rebalancing strategy:

1. Manage risk and emotion: Once you construct the appropriate allocation for your goals, stick to it with an easy-to-follow, consistent rebalancing strategy. Trust your original judgment and remove the need for more decision-making. Keep emotions out of it.
2. Set a rebalancing “trigger.” Don’t obsess over which rebalancing strategy to choose and whether to implement a time or threshold-based trigger. No one strategy has historically outperformed. The most important thing is that you settle on a rule that you can stick to.
3. Minimize the transaction and tax costs of rebalancing. Examine ways to limit costs and boost tax efficiency. Tactics to consider include using tax-advantaged accounts and rebalancing with portfolio or external cash flows.

Rebalancing According to Your Life Stage

Your approach to portfolio rebalancing will evolve as you age since each period in your life will come with different financial needs, risk tolerance, and time horizons.

Early Career (20s to 30s)

In this stage, investors typically have a long time horizon and can afford to take on more risk. Rebalancing might focus on maintaining a high equity allocation to capitalize on long-term growth potential.

You’ll rebalance less frequently since your account balances will be lower—and thus have less drift. You’ll also be using the money you take in to allocate your assets and adjust them; you won’t be selling your investments as much during this period.

Mid-Career (40s to 50s)

As investors approach what often is their peak earning years, rebalancing is more critical. Here’s what investors at this time are more likely to need:

• More frequent rebalancing (semiannually or quarterly) as portfolio values grow
• Gradually shifting toward a more balanced allocation between stocks and bonds
• Considering more of the tax implications of rebalancing in taxable accounts
• Potentially incorporating new asset classes for further diversification

Pre-Retirement (50s to 60s)

This stage requires careful rebalancing to preserve wealth while still allowing your portfolio to appreciate in value. Here is what’s more typical during this period:

• More conservative asset allocation, potentially using a “bucket strategy” for near-term, medium-term, and long-term needs
• More frequent rebalancing (quarterly or even monthly) to manage risk
• Focusing more than previously on income-generating assets
• Considering the role of alternative assets for diversification

Early Retirement (60s to 70s)

Rebalancing in this stage focuses on preserving capital and generating income:

• Regular rebalancing to maintain a more conservative asset allocation
• Including required minimum distributions into the rebalancing strategy
• Potentially using a spending strategy that adjusts withdrawals based on the portfolio’s performance

Late Retirement (70s and beyond)

During this stage, the focus is on longevity risk and legacy planning:

• Maintaining a balanced portfolio to hedge against inflation and longevity risk
• Simplifying the portfolio for easier management
• Incorporating estate planning goals into the rebalancing strategy

Throughout all life stages, individual circumstances, risk tolerance, and financial goals should drive the rebalancing strategy—not these and other general principles. In addition, major life events (such as marriage, divorce, or inheritance) will cause you to reassess your overall investment strategies and goals.

These life stages often align well with one or more of these portfolio allocation strategies:

How to Minimize Transaction and Tax Costs When Rebalancing

An important part of investing is keeping costs as low as possible. Expenses eat into your returns, and they compound over time.

Rebalancing can be expensive if not executed correctly. Every time you buy or sell investments, you can incur transaction costs—whether brokerage fees (which tend to be minimal now) or bid-ask spreads. There are tax considerations, too. Selling investments can result in capital gains tax; investments held for less than a year create a larger tax bill.

This means you shouldn’t tweak your portfolio too often—don’t nitpick your portfolio to death. Stick to a set time frame to revise your portfolio and only act when thresholds are breached.

You should also consider using tax-advantaged accounts, like a pretax 401(k) or Roth IRA, offsetting capital gains with losses, and topping up your underweight asset classes with new contributions rather than by selling overweight holdings. Financial advisors can help you with the best strategies to keep costs to a minimum.

What Is Modern Portfolio Theory?

This framework has shaped the field of finance since its introduction by Harry Markowitz in the 1950s. Modern portfolio theory (MPT) aims to help investors maximize their expected returns for a given level of risk or lower risk for a targeted level of return.

MPT emphasizes the power of diversification in reducing overall portfolio risk. By combining assets that don’t move in perfect tandem with each other, investors can smooth out the ups and downs of their portfolio’s performance.

What Is the Efficient Frontier in Portfolio Construction?

The efficient frontier is a set of optimal portfolios that offer the highest expected return for a defined level of risk, or the lowest risk for a given level of expected return.

What Is the Best Rebalancing Strategy for a Small Portfolio?

There isn’t one best rebalancing strategy. It’s about finding the one that works best for you. Generally, rebalancing once a year should be enough. When you hit your anniversary, review your asset allocation to see if it has strayed from its original target and restore it to how it was before.

What Is the 3 Portfolio Rule?

The three-fund portfolio is a strategy of holding three types of mutual funds or ETFs. One would invest in U.S. stocks, another in international stocks, and the other in bonds.

Is There an Optimal Month to Rebalance Your Portfolio?

An optimal month can be determined by when your period is due or when you know you’ll have the time and motivation. Choosing a period that is easy to remember, such as at the beginning or end of the year, can be helpful.

What is the Rule of 69 in Investing?

Rule 69 is a calculation used by investors to estimate how much time is needed for their investment to double in value, assuming your returns are being compounded.

The Bottom Line

Most investors begin with a clear plan for their time frame, objectives, and risk tolerance and build a portfolio to match those needs.

However, the work doesn’t stop there. The value of the assets in the portfolio won’t all change in the same way, resulting in a gradual shift in the original weighting. In other words, it is necessary to periodically check in and restore order.

There are various ways to do this, with the most common strategies including rebalancing after a set interval or only when the asset allocation has drifted away from preset thresholds.

Reviewed by Charlene Rhinehart
Fact checked by David Rubin

The balance sheet, income statement, and cash flow statement are foundational to the financial reporting of any company. Public companies are considered to be held to a higher standard because of their mandate to follow generally accepted accounting principles (GAAP). But, that hasn’t stopped companies from cooking their books to post much better than actual results in many categories. Enron, WorldCom, and Lehman Brothers are some of the most commonly known cases of fraud. And they aren’t the only ones.

Creative accounting can come in many different forms. It can also occur in many different ways. Keep in mind that certain loopholes exist that may help a company legally spin its financial reporting in a positive light. Spotting creative accounting practices on the balance sheet can be broken down into three categories for analysis: assets, liabilities, and equity. Here we’ll explore some of the ways each of the three categories of the balance sheet can be manipulated.

Key Takeaways

• You can spot creative accounting practices on a company’s balance sheet by analyzing its assets, liabilities, and equity.
• Overstating assets and/or understating liabilities leads to increased net income on the income statement.
• Fraudulently increasing net income can create the illusion of better performance by the company and management.
• Inflating assets and understating liabilities on the balance sheet can also improve key performance ratios.
• A company’s balance sheet ratios can be improved by manipulating the balance sheet.

Why Boost the Balance Sheet?

The balance sheet is closely tied to the income statement which is often where issues with asset revenue and/or liability expenses can help to create inflated revenues or understated expenses that result in a higher bottom line and retained earnings tied back to the balance sheet.

Companies that manipulate their balance sheets often want to increase their net income earnings power to create the appearance of a stronger financial condition or stronger management performance. After all, financially sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms. Companies may also be looking to overstate their overall asset position to potential creditors.

Note

Keep in mind that any scenario involving the illegal overstatement of assets, understatement of liabilities, or overall under- or overstatement of shareholders’ equity can reap short-term benefits but will have negative consequences when spotted.

Overvaluing Assets

Assets top out balance sheet construction. Like liabilities, assets are divided into current (12 months or less) and long-term (more than 12 months). Items commonly found in the asset category include: cash and equivalents, accounts receivable, inventory, and intellectual intangibles.

Provision for Doubtful Accounts

Accounts receivable (AR) have a direct link to revenues on the income statement. Companies that use accrual accounting can book revenue in accounts receivable as soon as a sale is made. Thus, the processing of accounts receivable can be one high-risk area for premature or fabricated revenues.

AR may be overstated because of inappropriate planning for doubtful accounts. Prudent companies typically take proactive measures for AR defaults. By not doing so, this can inflate earnings. It is up to each company to analyze and estimate the percentage of accounts receivables that regularly go uncollected. If there is no allowance for doubtful accounts, AR will receive a temporary boost in the short term.

Investors may detect when the reserves for doubtful accounts are inadequate. Accounts receivable will not be fully turned into cash, which can show up in liquidity ratios like the quick ratio. Write-downs will also need to be made to revenues. If accounts receivable make up a substantial portion of assets and inadequate default procedures are in place this can be a problem. Without doubtful account planning, revenue growth will be overstated in the short term but potentially retracted over the longer term.

Revenue Acceleration

In the asset category, companies can also overstate revenues through acceleration. This could come from booking multiple years of revenue at once. Companies may also manipulate revenues by comprehensively booking a recurring revenue stream upfront rather than spreading it out as it is expected to be received. Revenue acceleration is not necessarily illegal but it is not usually a best practice.

Inventory Manipulation

Inventory represents the value of goods manufactured but not yet sold. It is usually valued at wholesale but sold with a markup. When inventory is sold, the wholesale value is transferred over to the income statement as the cost of goods sold (COGS), and the total value is recognized as revenue. Overstating any inventory values could lead to an overstated COGS, which can reduce the revenue earned per unit.

Some companies may look to overstate inventory to inflate their balance sheet assets for the potential use of collateral if they need debt financing. It is typically a best practice to buy inventory at the lowest possible cost to reap the greatest profit from a sale.

One example of manipulated inventory includes Laribee Wire Manufacturing, which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it lost $6.5 million.

Investors can detect overvalued inventory by looking for telling trends like large spikes in inventory values. The gross profit ratio can also be helpful if it is seen to fall unexpectedly or to be far below industry expectations. This means net revenues may be falling or extremely low because of excessive inventory expensing. Other red flags may include:

• Higher inventory levels than sales
• Higher inventory levels than total assets
• A decrease in inventory turnover
• An increase in the cost of sales as a percentage of sales

Any unusual variations in these figures can be indicative of potential inventory accounting fraud.

Subsidiaries and Joint Ventures

When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary. These investments are booked as assets, which can leave the door open for companies to potentially use subsidiaries, ownership investments, and joint ventures for fraud—oftentimes, off-balance sheet items are not transparent.

Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and dividends received. Gains on these investments inflate assets and also lead to higher net income which carries over to the retained earnings portion of shareholders’ equity. While these investments are reported on the balance sheet and income statement, the methodologies can be complex and may create opportunities for fraudulent reporting.

Investors should be cautious—and perhaps take a look at the auditor’s reliability—when companies utilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U.S.-based company operating in China through various subsidiaries in which it appears to exert control could create an environment ripe for manipulation.

Note

Inflating assets can lead to higher revenues or higher inventory values that can make a company’s asset position stronger than it actually is.

Undervaluing Liabilities

Undervaluing liabilities is a second way to manipulate financial statement reporting from the balance sheet. Any understatement of a company’s expenses can be beneficial in boosting bottom line profits.

Contingent Liabilities

Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee, or the date payable. For example, warranty obligations or anticipated litigation losses may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating them or downplaying their materiality.

Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income and shareholders’ equity.

Investors can watch for these liabilities by understanding the business and carefully reading a company’s footnotes, which contain information about these obligations. Lenders, for example, regularly account for uncollected debts incurred through defaults and often discuss this area when earnings reports are released.

Other Expenses

Some other ways companies may manipulate expenses can include: delaying them inappropriately, adjusting expenses around the time of an acquisition or merger, or potentially overstating contingent liabilities to adjust them in the future as an increase to assets. Moreover, subsidiary entities as mentioned above, can also be a haven for off-balance sheet reporting of some expenses that are not transparently realized.

Note

Ownership in non-transparent entities can raise red flags for off-balance sheet items that may be disguised within subsidiaries rather than fully integrated in a company’s bottom line results.

Pension Obligations

Pension obligations are generally a result of the present value of future payments paid to employees. They are ripe for manipulation by public companies since the liabilities occur in the future and company-generated estimates need to be used to account for them. Companies can make aggressive estimates to improve both short-term earnings as well as to create the illusion of a stronger financial position.

One way to potentially manipulate this is through the discount rate used. Increasing the discount rate can significantly reduce the pension obligation. Companies may overstate the expected return on plan assets. Overstating expected returns creates more assets from which to pay pension liabilities, effectively reducing the overall obligation.

Since pension obligations can be ongoing for a company, accountants could potentially make various adjustments over the full length of the obligations to favorably manipulate net income in the short term or at some time in the future.

Shareholders’ Equity

Shareholders’ equity consists of the value of stocks, any additional paid-in capital, and retained earnings, which are carried over from net income on the balance sheet. If a company overstates assets or understates liabilities it will result in an overstated net income, which carries over to the balance sheet as retained earnings and therefore inflates shareholders’ equity.

Shareholders’ equity is used in several key ratios that may be assessed by financial stakeholders when evaluating a company as well as for maintaining current financing arrangements such as credit lines.

Some of these ratios may include debt to equity, total assets to equity, and total liabilities to equity. It is also used to calculate return on equity (ROE), which is central to evaluating the overall balance sheet performance of a company as well as the performance of management. ROE is the result of net income over shareholders’ equity.

The Bottom Line

Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities. The goal is to increase net income, which comes with the integration of actions that also show on the income statement. Companies may seek to inflate their assets or understate their liabilities to present a stronger financial position for stakeholders who assess their willingness to provide new capital through debt or equity financing. Any dramatic spikes or decreases in a company’s assets or expenses can be reason for alarm and further investigation. Public companies are required to adhere to GAAP accounting but oftentimes use non-GAAP measures, which should also be investigated and understood by investors.

Public companies can be a better universe for the sourcing of investments for everyday retail investors because of the regulations that have been instituted by the Securities Exchange Commission. If an investor feels they may have spotted creative accounting that involves fraudulent reporting, a review of publicly available audit statements and related financial disclosures can be the first place to look. Sometimes though, methods may be hidden, which can lead to shareholder investigations and potentially lawsuits if solid evidence is found for unlawful manipulations. Reading the financial statements, understanding a company’s business, and integrating an appropriate knowledge for spotting questionable practices can be important steps for all investors to take before making substantial investments. Staying away from questionable investments or taking proactive steps to move out of investments when creative accounting measures have been spotted can also be prudent steps to take.