A balance sheet is also referred to as a statement of financial position and is one of the most important financial statements used in the business and personal fields. It gives a special moment’s view of the financial position of an entity encompassing assets liabilities and the owners interest. In finance the balance sheet is a critical tool for evaluating the financial condition and the financial longevity of the enterprise.
It contains fundamental figures that are considered by various users including investors creditors managers and even regulatory bodies with the aim of making performance evaluations. To that extent this essay goes further in a description of the balance sheet in finance by explaining the details of its components its application in financial analysis its uses for different users and the way it aids in long term financial planning.
Components of Balance Sheet
However to appreciate the importance of a balance sheet it would be helpful to understand the major elements in time. Each of these parts provides a different lens through which to assess an entity’s financial health. Each of these parts provides a different lens through which to assess an entity’s financial health
Assets
Assets represent everything that the business owns and are divided into two main categories current assets and noncurrent assets or long term assets.
Current Assets
These are current assets which in one way or the other are likely to be turned into cash or used up within a year. Examples of current assets are cash receivables and stocks. This is because the current assets are used to fix the company’s liquidity position they are the assets that are easily transformable into cash to meet the short term liabilities.
Non current Assets
These are the assets that give value in the future and take longer than one year usually more than one year. Some of them are property plant and equipment (PP&E) intangible assets such as patents and investments. All of these assets are used to ascertain the long term sustainability and growth of a given firm.
Liabilities
Debtors are the amounts that are owed to outside parties or liabilities of the business. Just as with assets they are subdivided into current and non current ones.
Current Liabilities
These are liabilities that are due within a year such as accounts payable short term loans and other expenses that are likely to be incurred in the short term. Current liabilities are matched with current assets to determine the degree of liquidity.
Non current Liabilities
These are long term debts that are due after one year such as long term loans and bonds payable. Non Current liabilities also help users understand the company’s long term financial obligations and level of leverage.
Owners Equity
It is also referred to as shareholders or stockholders equity which is the excess of an entity’s total assets over total liabilities. It consists of invested capital amounts owed to it in earnings and reserves. Equity can be further divided into
Common Stock
This relates to the funds that are obtained from shareholders in consideration of shares that are offered to them.
Retained Earnings
These are the profits that have been retained within the business and not distributed to the shareholders as dividends.
Treasury Stock
This relates to any stock that the company had repurchased.
Importance of Balance sheet in Analysis
Liquidity Analysis
Since it is one of the major components of a company’s structure the balance sheet has an important function of indicating its level of liquidity. Liquidity is the ability of an entity to sell its assets quickly so as to pay for its short term liabilities. A lack of liquidity can make it easier for a firm to honour its obligations in the short run thereby raising solvency concerns.
Liquidity is calculated through the use of financial ratios such as the current ratio which is calculated as the ratio of current assets to current liabilities and the quick ratio which is the ratio of current assets excluding inventory to current liabilities. A high liquor ratio is good because it shows that the company is in a form of meeting its obligations while a low liquor ratio is bad because it shows that the company is in a form of financial distress.
Solvency and Leverage
The balance sheet also has a significant use in valuing Solvency which has a general meaning corresponding to the capability of a company to pay off long term obligations in the future. A solvency ratio for instance debt to equity (total liabilities/shareholders equity) gives an understanding of how a firm is financing its operations debts or equity wise.
The ratio of debt to equity is also high which means that the company has a high amount of debt which raises the financial risk of the firm when the earnings are low or fluctuating. A lower debt equity ratio normally means that the company has less credit obligation than the equity obligation and therefore can be considered to be in a better financial position than its counterpart with a high debt to equity ratio.
Asset Efficiency
The balance sheet provides the base for understanding how effectively the company turns the assets into revenues. By comparing total assets to revenue or other performance measures analysts will be in a position to deduce the efficiency by which the management is deploying the company’s resource base.
It measures the company’s relative efficiency and profitability in terms of the total working capital and fixed assets. Hence a higher ROA means better utilisation of the company’s assets and strong management.
Capital Structure Analysis
The balance sheet brings out the proportion of a firm’s capital structure an aspect that shows how many of the firm’s assets are financed by creditors as opposed to investors. This is important in comprehending the company’s level of gearing as well as the associated risk levels. Capital structure is issued because investors and creditors have a special focus on it in regard to the default risk and the opportunities for the company’s growth.
Business organisations that have a greater percentage of debt in their capital structure will have higher fixed charges thus reducing their profitability. On the same note a firm that has a high proportion of equity financing may be considered as having underutilised its debt capacity. This can lead to the bypassing of important tax shields or any opportunities to finance growth through long term debt.
Valuation and Investment Decisions
Balance sheets are also very important in business valuation exercises. Through balance sheet information investors determine several value earnings ratios such as the price book (P/B) ratio that compares a company’s stock market value to its book value a measure calculated as total tangible assets minus total liabilities.
When a company has a lower P/B ratio compared to its peers it could mean that its price is low relative to its book value and therefore the company might be undervalued. In contrast a high ratio implies an overvaluation of the company’s stock. Additionally the information in balance sheets is useful in the construction of the commonly used discounted cash flow (DCF) models in the evaluation of companies.
Dividend Valuation Model
This model enables investors to decide whether a company’s stock is overpriced or under priced based on estimated future cash flow and discounted to present values.
Importance for Different Stakeholders
Investors
It is obvious that for investors the balance sheet remains a very crucial tool when determining the financial position and risks of the company in question. In general a sound capital structure is a reliable sign that a company is well managed with resources to meet exigencies or expand in times of cyclical downturns. Analyzers in particular also focus on the balance sheet in order to find out that the company carries an appropriate amount of debt and that it is liquid enough.
Equity investors focus on the numbers of shareholders equity and retained earnings more than any other group of investors. A higher level of retained earnings also implies that the company is creating enough profits and effectively ploughing them back into its operations which means the possibility of future growth and therefore greater shareholder value.
Creditors
Banks and bond holders mainly depend on the balance sheet to determine the creditworthiness of the business. These include Solvency where they assess the ability of the company to service short term or long term loans credit standing where they determine the strength of the company’s balance sheets and its ability to respond to creditors demands for loans or credit facilities.
The debt assets ratio and the interest coverage ratio which is defined as EBIT divided by interest expenses are two popular measures used in ascertaining a firm’s ability to meet its interest obligations.
Managers
As for company management the balance sheet is used for decision making and for internal bench marking. It offers an Seye view of the company’s assets and liabilities to allow the management to make decisions on the best utilisation of the resources as well as prepare for future expansion.
Moreover the balance sheet helps in highlighting the fact the company has overstretched its borrowing capacity or the opposite it has under invested and is required to make decisive actions including debt refinancing share repurchase or acquisition of other assets.
Regulators
The regulatory authorities extensively utilise the following balance sheets in ensuring compliance with the set accounting standards as well as boosting financial transparency among the enterprises. Companies especially those that go public release their financial statements such as the balance sheet and these are vital to regulators to ensure that investors are protected and that there is fairness within the market.
When companies have operational balance sheets that are volatile or controversial they may encounter legal ramifications or fines. Also financial institutions and banks are subjected to regulatory capital requirements which are used to monitor organisations balance sheets and to ensure that these institutions have adequate capital.
Mergers and Acquisitions
In mergers and acquisitions (M&A) an enterprise balance sheet document is essential in establishing the value of the target company. In line with this buyers examine the sources of dollars to access the target’s asset base as well as the structure of liabilities and equity to determine an offer price.
Acquirers are keen on items such as goodwill intangible assets as well as liabilities which may have a profound effect on the performance of the merged contender.
Growth and Expansion
That’s why the balance sheet of the firm is useful to companies that anticipate their growth and wish to enter new markets or launch new products. This is because strong liquidities and a good asset base may be important factors that have been known to necessitate an aggressive firm performing growth strategies.
On the other hand a company with high leverage or bad liquidity status could postpone or reduce expansion strategies due to the fact that they would want to keep the company’s financials manageable.
Risk Management
Another component of efficient risk management is the company’s ability to understand the specifics of the balance sheet. Now it is high time for companies to evaluate their risks with reference to their liquidity profile debt levels and asset structures. This implies that having a number of illiquid assets or excessive debts may place a firm in a precarious position during an economic meltdown or other such circumstances.
Thus when they go through the balance sheet they may find out that the company has some risks which include a high level of debt. The company may need to restructure the debts sell some non core assets or source more capital.
Accompanying Restrictions of Using Balance Sheet
While the balance sheet is an essential tool for financial analysis it has its limitations
Historical Cost Accounting
Another criticism of this analysis of the balance sheet is that it utilises historical cost accounting. Resources are usually stated at the original cost and not at the current values of cost which leads to lower values of certain resources especially in inflationary periods or in businesses where resources depreciate.
Omission of Intangibles
The vast majority of asset values that is elements deemed to have a value that isn’t captured by financial figures are not reflected on the balance sheet unless they were purchased. That may result in an inadequate assessment of the actual value of the company especially in the industries where the intangible value added plays a major role such as the IT or pharmaceutical industries.
Snapshot in Time
Specifically the balance sheet shows a company’s financial statement at a particular period. It does not concern fluctuations in financial standing or trend information which might be useful for decision making. However at this rate the balance sheet needs to be analysed with other statements of the organisation such as the income statement and the cash flow statement.
Subject to Management Discretion
Some of the components of the balance sheet are valuative which include the method of depreciation and provision for bad and doubtful debts. This opens up the risk of manipulation or what is often termed as window dressing whereby the management may use the books of account to give the firm’s financial position a better picture than what it is.
Using Balance Sheet as a Predictor
A balance sheet is not simply a snapshot of what a company possesses or is owing at some fixed point in time it is an instrument of the planner and the analyst and it is prognostic as well as diagnostic. Such elements enable the prediction of future performance after identifying the patterns associated with the balance sheet. This analysis could entail the evaluation of changes in such categories as asset intensity changes in leverage ratios and trends in liquidity.
Consistent increases in the levels of inventory or receivables for example would imply future cash flow problems or over production and hence the need to exercise better control over inventory. In the preparation of the forecasts the balance sheet is one of the essential sources used in preparing the pro forma statements. These are financial statements that work as a financial predictive instrument used in planning for future financial positions with probable assumptions.
It enables a firm to forecast future balance sheets so that it can determine its capital requirements assess financing opportunities and recognize when the firm is vulnerable to a balance sheet constraint. This foresight is important when it comes to planning and anticipating the future so as to avert any cash flow problems which may consequently affect the operations of the business.
Managing Balance Sheets using Technology
The occurrence of the digital age has greatly influenced how balance sheets are prepared analyzed and interpreted. The relative use of technologies particularly artificial intelligence machine learning and big data analytics has improved the capability of deriving realtime information from balance sheet information. With the help of software many balance sheets can be prepared today and they are less likely to be prepared with errors as they were previously done manually.
Previous data from balance sheets is being used through machine learning to recognize signs as well as to make forecasts. For instance AI is capable of alerting the auditor to certain entries or otherwise large anomalies from the typically recorded financial patterns that could be indicative of for instance fraud or the firm’s financial difficulties. Also big data can be applied to other components of the balance sheet and reveal the nature of connections between diverse items.
This may be to explain the relationship between assets and liability or the impact of debt mix on profitability. Some of the financial management systems are cloud based which makes it possible to update the balance sheet in realtime and provide an instance view of the financial health of a business. This realtime reporting is especially useful in industries where assets keep on fluctuating especially in companies dealing in future commodities or even bitcoin because the value may change within a very short duration.
Relationship Between Balance Sheets in Sustainability
Recently another technique in financial analysis has been linked to taking ESG factors into account while preparing and analysing balance sheets. Consumers and other users of products shareholders and other stakeholders want not only to know about businesses financial commitments but also about their environmental and social ones. This evolution has necessitated balance sheet change so that the ESG elements can be accurately captured.
For instance many organisations are measuring and disclosing contingencies arising from environmental threats including costs of carbon emissions treatment of wastes and risks of litigation due to non compliance with environmental rules and policies. On the asset side such potential investments may include investments in green technologies or sustainability initiatives that may help create more value in the long run.
Conclusion
Let’s begin by saying that the balance sheet is one of the pillars of financial analysis and a crucial tool that helps in the evaluation of the company’s financial standing. A balance sheet gives much detail of a company’s resources the assets which are owed by the business the liabilities and the business owners claim on those resources the equity which is useful to investors creditors managers and regulators.
In every liquidity or solvency ratio asset efficiency of capital structure ratio the balance sheet is utilised as the fundamental tool of the numerous financial ratios that are employed in investment and credit analysis. Amid all these shortcomings it is still an invaluable tool in finance. Still it can only be understood with other financial statements and has to be changed for management discretion or the market value changes in order to give a clear overview of the financial situation of a company.
Finally balance sheet strength is mainly viewed as a sign of financial solidity and risk management alongside future oriented growth opportunities which in turn makes the statement a critical tool for directing strategic management in today’s increasingly diversified and challenging financial context.