Balance Sheet Purpose

Updated on May 23, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Purpose of the Balance Sheet?

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

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

  • The Balance sheet is of great utility for internal, external, and potential stakeholders/investors.
  • The Balance Sheet of any organization generally provides details about debt funding availed by the Organization, Use of debt and equity, Asset Creation, Net worth of the Company, Current asset/current liability status, cash available, fund availability to support future growth, etc.

Key Takeaways

  • The balance sheet’s primary purpose is to provide a snapshot of a company’s financial position at a specific time, presenting a summary of its assets, liabilities, and shareholders’ equity.
  • The primary purpose of the balance sheet is to provide stakeholders, such as investors, creditors, and management, with an understanding of the company’s financial health, solvency, and liquidity.
  • The balance sheet helps assess the company’s ability to meet its short-term and long-term obligations and evaluate its capital structure and financial leverage.
  • The balance sheet is a foundation for financial analysis, ratio calculation, and decision-making regarding investments, lending, and overall financial management.
Purpose of Balance Sheet Meaning

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
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 receivables  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 period. For example, management may decide to reduce the debt from its current level based on balance sheet representation as they feel it’s relatively higher than the industry benchmark. In addition, control of the company may take a call on liquidity improvement measures if they think that its working capital cycle is relatively stretched based on the Current asset/current liabilities status on the Balance Sheet. Therefore, the Balance Sheet serves a larger purpose for the Company’s Management to identify existing issues, anticipate future problems, and chart out a course correction plan.

Accounting for Financial Analyst (16+ Hours Video Series)

–>> p.s. – Want to take your financial analysis to the next level? Consider our “Accounting for Financial Analyst” course, featuring in-depth case studies of McDonald’s and Colgate, and over 16 hours of video tutorials. Sharpen your skills and gain valuable insights to make smarter investment decisions.

#2 – Investors of the Company/Potential Investors

Investors in the Company Use the Balance Sheet, along with other financial statements, to analyze the company’s financial soundness. They also use trends of the last few years by analyzing the numbers in a financial statement to understand the company’s future growth potential and make a decision to stay invested in the company and increase/decrease the shareholding in the company.

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

#3 – Banks/Financial Institutions

A balance sheet serves a critical purpose in deciding whether to lend or not to lend to Banks. As a Balance Sheet gives a stock of existing debt and equity composition and status of current assets and current liabilities, it helps Banks to analyze if the company has already over-borrowed and has limited ability to repay the debt. It also allows lenders to analyze the company’s liquidity situation, decide on an amount of working capital/short-term loan, set the drawing power limit against the short-term loan, monitor the 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 find 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 loan.

That is precisely why bankers stipulate a condition for Companies to furnish their quarterly/annual Balance Sheets promptly.

#4 – Customers/Potential Customers

The Balance Sheet of an Automotive parts manufacturing company, a parts supplier to a Car Manufacturer, is critical. Because a Car Manufacturer would like to establish a relationship with a financially strong and stable company. A Car Manufacturer would not like to face the risk of its suppliers stopping the operations and 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 analyze the company’s existing debt, current liquidity situation, and fund availability to support future growth to establish the company’s financial soundness.

#5 – Raw Material Suppliers/Creditors

The Balance Sheet of the Company helps Suppliers/Creditors understand the company’s financial strength. 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 Companies 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 sheets to detect any misdeeds being done by Companies in the larger interest of retail investors in publicly traded companies.

How does it help in Ratio Analysis?

The balance sheet is used for Ratio Analysis as given in the following table-

Liquidity Ratio Analysis

Turnover Ratios

Operating Efficiency Ratio Analysis

Business Risk

Financial Risk

Other financial ratios, such as profitability ratios and return ratios, can be calculated by using all financial statements (Balance Sheet, P&L Statement, and Cash Flow). Multiple stakeholders may use these ratios, such as Investors, lenders, management, and business partners, to analyze any organization.

Conclusion

  • The company’s Balance Sheet gives a financial snapshot of the Organization at a specific point in time. The Balance sheet provides details of the company’s capital structure, Gearing, liquidity condition, cash availability, asset creation over time, and other company investments.
  • It is useful when multiple stakeholders are involved with the company and often becomes a critical part of decision-making by stakeholders.
  • Though the Balance Sheet alone has some limitations in providing complete financial health of the Company, the Balance Sheet, along with the Revenue Statement and Cash Flow provides a complete analysis of the organization’s financial health.
  • It is useful for banking regulators/Share market regulator/retail investors in the case of publicly listed companies.

Frequently Asked Questions (FAQs)

1. Why is the balance sheet important for investors?

Investors use the balance sheet to assess a company’s financial health and evaluate its ability to generate future cash flows. It helps them make informed decisions about investing in or valuing a company’s shares or securities.

2. How does the balance sheet help creditors?

Creditors, such as banks and lenders, use the balance sheet to evaluate a company’s creditworthiness and determine its ability to repay loans. It provides insight into the company’s assets, liabilities, and equity, allowing creditors to assess the risk associated with lending.

3. What is the difference between a balance sheet and an income statement?

While the income statement focuses on a company’s revenue, expenses, and net income over a specific period, the balance sheet provides a snapshot of the company’s financial position at a particular time.

4. How does the balance sheet help management in decision-making?

The balance sheet helps management make informed decisions about capital allocation, investment planning, and financial strategies. It provides:
1) A clear overview of the company’s resources and obligations.
2) Aiding in the assessment of liquidity.
3) Solvency.
4) Overall financial performance.

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, Ratio analyses, and practical examples. You may learn more about Accounting from the following articles –