Financial statements users read and analyze each statement to gain insights into a company’s operations. Each of these statements provides specific information that stakeholders will find useful. Usually, companies prepare these financial statements annually or quarterly. In some cases, companies may also present them for a longer or shorter period.
The primary financial statements include the balance sheet, income statement, cash flow statement and statement of equity. Similarly, companies prepare notes to the financial statements containing further information. Each financial statement has a purpose that differs from the others. Of these, the balance sheet has seven main purposes. However, it is crucial to understand what this statement is first.
What is the Balance Sheet?
The balance sheet is among the primary financial statements that companies prepare. Usually, it is the first statement that companies include as a part of the annual report. The balance sheet consists of a list of balances relating to the accounting systems. These balances present the remaining value in each part of a company’s operations.
The balance sheet provides an overview of the company’s operations. In essence, it offers users a snapshot of those operations at a specific time. Accounting standards require companies to report their assets, liabilities and equity in this statement. Each of these areas presents the components on the balance sheet. These components are also crucial in providing a picture of operations.
The balance sheet, also known as the statement of financial position, is a highly crucial financial statement. For most users, it helps calculate a company’s book value. Similarly, it shows its financial position at a specific time. Unlike the other financial statements, the balance sheet does not cover a particular period. Instead, it reports the assets, liabilities and equity at a specific time.
The balance sheet also ties together all financial accounts. It follows the accounting equation, which suggests total assets must equal the sum of equity and total liabilities. In essence, the balance sheet uses the same principle. It also gets information from the income statement, which is fundamental to equating the balances. The balance sheet presents this equation on two sides, the sum of which must equal at the end.
Overall, the balance sheet is a financial statement that reports a list of balances related to the accounting system. This statement differs from the other statements as it does not cover a specific period. Instead, it provides an overview of a company’s assets, liabilities and equity at a specific time. The balance sheet follows the accounting equation, presented in two sections.
What are the seven main purposes of the Balance Sheet you should know?
The purpose of a balance sheet may differ based on the needs of the stakeholders. However, it has some objectives that apply to all users. In essence, its primary purpose is to list all the balances from the financial accounts into a central location. However, it may also have various other objectives. Of those objectives, the seven main purposes of the balance sheet include the following.
Evaluate asset value
One of the primary components of the balance sheet includes assets. These are resources owned or controlled by a company that result in inflows of economic benefits in the future. In essence, assets help companies generate revenues. For stakeholders, it is crucial to understand the value of those resources. Since these resources can help make money, users want to understand their potential.
On top of that, a potential investor or acquirer would also want to evaluate a company’s asset value. By doing so, they can understand how much they are paying for the company. On top of that, investors also seek to understand how these assets contribute to revenues and profits. Therefore, the balance sheet can be a crucial tool to evaluate asset value.
Liquidity is a highly crucial factor for companies. Essentially, companies seek to be as liquid as possible for their given circumstances. For stakeholders, liquidity is also critical in how the company operates. In essence, it refers to how quickly companies can turn their assets into cash or cash equivalent items. The balance sheet can help assess a company’s liquidity.
Stakeholders can use the balance sheet to assess how many liquid assets a company has. Usually, they can look at those assets directly through the statement. However, they can also use liquidity ratios to understand how quickly a company turns those assets into cash. Either way, the balance sheet plays a critical role in determining liquidity.
Show financial position
One of the primary purposes of the balance sheet is to show a company’s financial position. As mentioned, it provides an overview of its assets, liabilities and equity at a specific time. In contrast, the other financial statements cover periodical information. While that information can also be beneficial, it does not show a snapshot of operations.
Overall, determining the financial position of a company is highly crucial. By doing so, users can understand the assets, liabilities and equity a company owned at that point. This information can also provide the basis for further calculations and analysis. It is also one of the reasons why the balance sheet is also called the statement of financial position.
Debt is a finance source that helps companies fund operations. However, it can also have adverse impacts on profits. On top of that, it increases the risks that companies face due to leverage. Therefore, users must know how much debt a company has accumulated from its past operations. The balance sheet can help in that regard.
The balance sheet provides a picture of a company’s debts. This information can help users evaluate their debt position. By doing so, they can understand the leverage a company has undertaken. For some stakeholders like creditors and lenders, this information is highly crucial. It dictates how much finance companies can generate.
Calculate financial ratios
Another main purpose of the balance sheet is to help users calculate financial ratios. This way, they can get crucial insights into a company’s operations. Financial ratios involve calculating the relative magnitude of one figure to another in the financial statements. The balance sheet plays a critical role in providing the basis for some of those ratios.
The balance sheet can help users calculate liquidity, gearing and performance ratios. While it may allow users to calculate some profitability ratios, it may not be essential. The balance sheet can help improve the information that stakeholders can get. In the absence of this financial statement, calculating those ratios is not possible.
The balance sheet includes balances from various accounts. Accounting standards also require companies to provide a comparative figure with those accounts. By studying those comparatives and using them in comparison, users can understand a company’s growth. Furthermore, users can also use historical positions as a reference to measure progress.
Users can also determine growth through other financial statements. However, those statements do not consider the company’s assets, equity and liabilities. Therefore, the balance sheet can be a better indicator of growth. With this statement, users can understand how the company’s operations have developed from the past.
Equity is the amount attributable to a company’s shareholders. This amount shows how much assets shareholders will get if the company liquidates. For most shareholders, it is a crucial metric to understand their role in the company. Similarly, it shows how much finance a company has raised through those shareholders.
Essentially, equity reveals the shareholders’ claim to the company. For most stakeholders, understand this claim is highly crucial. More specifically, investors and existing shareholders take an interest in it due to their rights to it. Creditors may seek this figure to understand the shareholders’ contribution.
The balance sheet is one of the primary financial statements prepared by companies. This statement provides crucial information about a company’s operations. Overall, there are several purposes of the balance sheet. Usually, these purposes differ based on the needs of the stakeholders. Of those, the seven main ones are available above.