Balance Sheet Purpose

What is the Purpose of the Balance Sheet?

The main purpose of the Balance sheet is to give the understanding to its users about the financial position of the business at the particular point of time by showing the details of the assets of the company along with its liabilities and owner’s capital.

The purpose behind the preparation of Balance Sheet is to provide the financial status of the company at any specific point of time to multiple stakeholders or to potential stakeholders (management, shareholders, lenders, creditors).

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Source: Balance Sheet Purpose (wallstreetmojo.com)

Top 6 Purpose of Balance Sheet for Stakeholders

#1 – Management of the Company

Purpose of Balance Sheet - Liquidity

source: Colgate SEC Filings

Management of the Company generally requires the details related to the Company’s debt funding status, liquidity situation assessment, trade receivablesTrade ReceivablesTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet.read more status, cash flow availability, the investment made in other assets, and fund availability for future expansion to plan the future course of activities for the next time period. Management may decide to reduce the debt from its current level based on balance sheet representation as they feel that it’s relatively higher than the industry benchmark. Management of the Company may take a call on liquidity improvement measures if they feel that the Company’s working capital cycle is relatively stretched based on Current asset/current liabilities status in the Balance Sheet. Therefore, the Balance Sheet serves a larger purpose for the Management of the Company in identifying existing issues as well as anticipating future problems and chart out a course correction plan.

#2 – Investors of the Company/Potential Investors

Investors in the Company Use Balance Sheet, along with other financial statements to analyze the financial soundness of the Company. They also use trends of the last few years by analyzing the numbers in a financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more to understand the future growth potential of the Company and to make a decision to stay invested in the Company, increase/decrease the shareholding in the Company.

Balance Sheet may also be used by potential investors or Companies looking to acquire businesses or looking to partner with Companies for their expansions.

#3 – Banks/Financial Institutions

Balance Sheet serves a very critical purpose of making a decision to lend or not to lend for Banks. As Balance Sheet gives a stock of existing debt and equity composition and status of current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more, it helps Banks to analyze if the Company has already over-borrowed, and it has limited ability to repay the debt. It also helps lenders analyze the liquidity situation of the Company, to decide on an amount of working capital/short-term loan, to set the drawing power limit against the short-term loan, monitoring of loan account, and most importantly, in decision-making for lending to a Company.

Purpose of Balance Sheet - Banks

For existing Banks, the Balance Sheet serves a critical purpose of tracking the fund flow and utilization of the already disbursed loan by analyzing the corresponding increase on the asset side. A careful analysis by Banks can help them in finding if the loan disbursed for a specific purpose is being used for the same purpose or being diverted by the Company for something else, which can give an early warning signal for a potential default in a loan.

That is precisely the reason bankers stipulate a condition for Companies to furnish their quarterly/annual Balance Sheet in a timely manner.

#4 – Customers/Potential Customers

The Balance Sheet of an Automotive parts manufacturing company, which is a parts supplier to a Car Manufacturer, is very critical. Because a Car Manufacturer would like to establish a relationship with a company that is financially strong and stable. A Car Manufacturer would not like to face the risk of its suppliers stopping the operations and so the supply of parts to the Car Manufacturer, which ultimately affects the operation of the Car Manufacturer. Therefore, in such a situation, the Car Manufacturer will do its own analysis of the Company’s existing debt, current liquidity situation and fund availability to support future growth to establish the financial soundness of the Company.

#5 – Raw Material Suppliers/Creditors

The Balance Sheet of the Company helps Suppliers/Creditors to understand the financial strength of the Company. A Company with relatively stronger financials enjoys better trust/comfort /terms from its creditors.

#6 – Government Agencies/Banking Regulators/Stock Market Regulators

Bankers do business with public deposits. Therefore, banking regulators use the Balance Sheet of the CompaniesBalance Sheet Of The CompaniesA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more to detect any possible malpractices/ fraudulent activities being undertaken by the Company in the larger public interest. Similarly, Stock market regulators also keep an eye on the Companies by screening through their financial statements/balance sheet to detect any misdeeds being done by Companies in the larger interest of retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more in publicly traded companies.

How does it help in Ratio Analysis?

Balance Sheet is used for Ratio AnalysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more as given in the following table-

Liquidity Ratio Analysis

Turnover Ratios

Operating Efficiency Ratio Analysis

Business Risk

Financial Risk

There are other financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more, such as profitability ratios, return ratios, which can be calculated by using all financial statements (Balance Sheet, P&L Statement, and Cash Flow). These ratios may be used by multiple stakeholders such as Investors, lenders, management, business partners to get a complete analysis of any organization.

Conclusion

This has been a guide to the Purpose of Preparing a Balance Sheet. Here we discuss the purpose of the Balance Sheet for various stakeholders and for Ratio Analysis along with practical examples. You may learn more about Accounting from the following articles –

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