What is the purpose of a balance sheet?
There could be several reasons you need to find out the financial status of a company. You may wish to invest in the company or even acquire it. You could be seeking employment in the company. In all these cases, you would want it to remain financially viable in the coming years. It may even be that the company approached you for a loan. Before extending the loan, you would need to be certain that the company could repay the loan.
The best way to get a feel for the financial status of a company is by looking at its balance sheet. But first, you need to know the primary purpose of a balance sheet.
What is a balance sheet?
A balance sheet is like a snapshot of a company’s financial performance at any point in time. It is a list of the company’s liabilities and assets on a particular date. Companies generally draw up a balance sheet at the end of an accounting period.
A balance sheet has two columns—liabilities and assets. By definition, a company’s total liabilities and total assets need to match perfectly. The account is balanced by ensuring that the total liability is equal to the total asset.
When do businesses draw up a balance sheet?
Businesses can draw a balance sheet for any date. But most businesses prepare one on the last date of every quarter. In most countries, government regulations make it mandatory for a company to prepare its balance sheet at the end of every half-year and year. Public companies generally publish their quarterly, half-yearly, or annual balance sheet.
What is the importance of a balance sheet?
A balance sheet is one of the four most crucial documents of a company. The other three are profit and loss account, cash flow statement, and shareholding pattern. A balance sheet informs you about everything going on in the organisation at a certain point in time. The balance sheet is important to the following stakeholders for distinct reasons:
- Key decision makers: This includes the board of directors as well as officials like the CEO and the CFO. The balance sheet lets them assess the present scenario. They can also make changes if required. For example, the key decision maker may find that the company has a heavy fixed-asset structure. In such a case, they may dispose of fixed assets and convert them to capital gains.
- Potential investors: Before making an investment, potential investors need to check whether the company is likely to be profitable in the future. Potential investors make use of balance sheet ratios to analyse the balance sheet. Such ratios include the debt-to-equity or liquid assets-to-current liability ratios. They give investors an idea of how much returns they can expect.
- Potential lenders: The balance sheet goes a long way in establishing the creditworthiness of a company. Before lenders approve a loan, they need assurance that the company will be able to repay it. The balance sheet tells them whether the company has enough liquid assets in hand to cover the loan liability.
The balance sheet is also an important document for existing shareholders, employees, and vendors who sell on credit. Finance magazines, newspapers, and news shows also make use of balance sheets. They use the numbers to provide informed suggestions to their readers or viewers. Hence, the balance sheet is a very important document that you must know how to read.