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 CompanyNet Worth Of The CompanyThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus., 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 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. 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. 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. 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., 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 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. 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. 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. as given in the following table-
Liquidity Ratio Analysis
- Current Ratio AnalysisCurrent Ratio AnalysisThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities
- Quick Ratio Analysis
- Cash Ratio InterpretationCash Ratio InterpretationCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.
- Receivables Turnover Ratio Analysis
- Inventory Turnover Ratio AnalysisInventory Turnover Ratio AnalysisInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory.
- Accounts Payable Turnover Ratio Analysis
- Cash Conversion CycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.
Operating Efficiency Ratio Analysis
- Asset Turnover Ratio AnalysisAsset Turnover Ratio AnalysisThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.
- Net Fixed Asset Turnover
- Equity TurnoverEquity TurnoverThe equity turnover ratio depicts the organization's efficiency to utilized the shareholders' equity to generate revenue. It is evaluated by dividing the total sales from the average shareholders' equity.
- Financial Leverage AnalysisFinancial Leverage AnalysisFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively.
- Total Leverage
- Leverage Ratio AnalysisLeverage Ratio AnalysisDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.
- Debt to Equity Ratio AnalysisDebt To Equity Ratio AnalysisThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level.
- Interest Coverage Ratio InterpretationInterest Coverage Ratio InterpretationThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.
- Debt Service Coverage RatioDebt Service Coverage RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending.
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., 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 FlowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. 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 –