The purpose of the balance sheet

The purpose of the balance sheet is to reveal the financial status of a business as of a specific point in time. The statement shows what an entity owns (assets) and how much it owes (liabilities), as well as the amount invested in the business (equity). This information is more valuable when the balance sheets for several consecutive periods are grouped together, so that trends in the different line items can be viewed.

There are several subsets of information that can be used to gain an understanding of the short-term financial status of an organization. When the current assets subtotal is compared to the current liabilities subtotal, one can estimate whether a firm has access to sufficient funds in the short term to pay off its short-term obligations.

One can also compare the total amount of debt to the total amount of equity listed on the balance sheet, to see if the resulting debt/equity ratio indicates a dangerously high level of borrowing. This information is especially useful for lenders and creditors, who want to know if the extension of additional credit might result in a bad debt.

Investors like to examine the amount of cash on the balance sheet to see if there is enough available to pay them a dividend. However, this judgment may need to be adjusted based on the need to invest additional funds in the business.

A potential acquirer of a business examines a balance sheet to see if there are any assets that could potentially be stripped away without harming the underlying business. For example, the acquirer can compare the reported inventory balance to sales to derive an inventory turnover level, which can indicate the presence of excess inventory. The same comparison can be applied to accounts receivable. Or, the fixed asset total can be compared to sales to derive a fixed asset turnover measure, which is then compared to best-in-class companies in the same industry to see if the fixed asset investment is too high.

In short, the purpose of the balance sheet is basically to reveal the financial status of an organization, but users may focus on different information within the statement, depending on their own needs.

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The Balance Sheet