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).
- The Balance sheet is of great utility for Internal Stakeholders, External Stakeholders, and also to 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.
Top 6 Purpose of Balance Sheet for Stakeholders
#1 – Management of the Company
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 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 statement 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.
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#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 assets and current liabilities, 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.
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 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 sheet 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?
Balance Sheet is used for Ratio Analysis as given in the following table-
Liquidity Ratio Analysis
- Receivables Turnover Ratio Analysis
- Inventory Turnover Ratio Analysis
- Accounts Payable Turnover Ratio Analysis
- Cash Conversion Cycle
Operating Efficiency Ratio Analysis
- Financial Leverage Analysis
- Total Leverage
- Leverage Ratio Analysis
- Debt to Equity Ratio Analysis
- Interest Coverage Ratio Interpretation
- Debt Service Coverage Ratio
There are other financial ratios, 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.
- The Balance Sheet of a company gives a financial snapshot of the Organization at a specific point in time. Balance Sheet provides details of the Company’s capital structure, Gearing, liquidity condition, cash availability, asset creation over time, and other investments of the Company.
- It is useful when multiple stakeholders involved with the Company and many a time becomes a critical part of decision making by stakeholders.
- Though Balance Sheet alone has some limitations in providing complete financial health of the Company, Balance Sheet along with Revenue Statement and Cash Flow provides a complete analysis of the organization’s financial health.
- It is useful for banking regulator/Share market regulator/retail investors in the case of publically listed companies.
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 –