Purpose and Importance of a Balance Sheet
A balance sheet or statement of financial position provides a picture of the financial status of an entity at a specific period. Generally, it is drawn up at the end of a month, quarter, or fiscal year.
The balance sheet shows business owners his/her assets, liabilities, and net value or equity in the business. The value of a balance sheet changes every time the owner accepts cash, settles charges for incurred expenses, and gives bonds to a client. In mathematical term
Assets = Liabilities + Owners’ Equity
This statement adheres to a standard accounting configuration wherein assets and liabilities are indicated in all businesses, irrespective of the size or nature. Comparing balance sheets can perfectly illustrate the financial health of a business. Combined with other financial statements, the balance sheet establishes an advanced examination and determination of the businesses’ worth.
Preparing a Balance Sheet
In a two-column balance sheet, the assets are designated on the left side while liabilities are shown on the right side. For a one-column balance sheet, the assets are indicated first, followed by liabilities and net worth.
The first step in preparing a balance sheet is to fill out the Current Assets Section, Fixed Assets Section, and Other Assets Section on the worksheet. Then, compute for the business’ Total Assets. Afterwards, fill in the Liabilities Section of the worksheet and determine the Total Liabilities. Lastly, complete the Net Worth Section and measure the financial ratios associated with a balance sheet.
Assets can be classified as either current or fixed. Essentially, assets are listed based on their liquidity or how fast they can be converted into cash within an operating cycle. Generally, an operating cycle persists for 60 to 180 days or any time between the commencement of production to the acceptance of payment from the purchased goods or service.
- Current Assets
These can be in the form of cash, bonds, accounts receivable, prepaid expenses, and anything that is liquid within the financial year or throughout the course of the business.
- Cash are assets that are in the form of money on hand, in banks, or petty cash.
- Accounts receivable or A/R is the money presently owed by customers to businesses. This happens when clients purchase items through credit. Normally, accounts receivable are converted into cash in a short span of time. However, there are some cases wherein due to bad credit, the business will consider to write-it-off. Hence, a separate fund called allowance for bad debt will be used to off-set these losses.
- Prepaid expenses or unexpired expenses are paid items or services that are not yet consumed or utilized. Examples include security deposit for a rent or lease and lump sum for broadcast agencies.
The summed up current assets represent the Total Current Assets on the balance sheet.
- Fixed Assets
Fixed assets or long-term assets are assets that generate revenue but are kept, maintained, and are not intended for resale. Examples are: furniture and fixtures, motor vehicles, machineries and equipment, and intangible assets such as patents and copyrights.
An online course material from Massachusetts Institute of Technology described liabilities as “possible future economic sacrifices emerging from current obligations of a specific entity to transfer assets or give services to another entity hereafter as an outcome of previous undertakings or events. “
In general, liabilities can be classified into current and long-term categories. If assets are arranged on the balance sheet in order of their liquidity, liabilities are configured depending on the time required to settle them. For instance, accounts payable are listed first since they are usually paid within 30 days.
- Current Liabilities
These are services that are supposed to be carried out or liabilities that are expected to be settled through the assets identified in the current section of the balance sheet. In terms of cash, these are expected to be settled in one year. Deferred revenues, accounts payable and interest are all encompassed in the current liabilities.
- Long-Term Liabilities
These are debts that must be settled in one or more years. These can be long-term bank loans, mortgages, and bonds.
Analyzing Your Balance Sheet
Through the information that businesses disclosed on their balance sheets, liquidity and leverage ratios can be calculated. These ratios aid owners in managing their business and in deciding business matters. By making ratio analyses, loan officers can assess the creditworthiness of potential borrowers. More so, business owners can compare and contrast their company with others.
These four financial ratios can be measured using the data on the balance sheet: current ratio, quick ratio, working capital, and debt/worth ratio.
- Current Ratio
The current ratio or liquidity ratio gauges the financial strength of the business. The equation for the current ratio is,
Current Ratio = Total Current Assets / Total Current Liabilities
The result will determine whether the business has sufficient assets to comply with the deadline in settling current liabilities with a margin of safety. The rule of thumb establishes a strong current ratio at two. A high current ratio signifies that cash is not being used in an optimal way.
The current ratio can be ameliorated by upturning the current assets or curtailing the current liabilities. These can be done by settling debts, marketing fixed assets, or securing a loan that is due in the next few years.
- Quick Ratio
Also referred as “acid test” ratio, quick ratio measures the liquidity of an entity. This can be measured using this equation,
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The resulting ratio should be between 0.50 and 1. This test will determine if the business can settle its liabilities in the event of calamities.
- Working Capital
The working capital shows the amount of liquid assets the entity possesses that can be used in developing the business and producing shareholder value. Lenders usually rely on the working capital in assessing an entity’s ability to get through hard times. Typically, borrowers must maintain a specific level of working capital, as prescribed in loan agreements.
The working capital can be measured using this mathematical statement,
Working Capital = Total Current Assets – Total Current Liabilities
The current ratio, quick ratio, and working capital are used in evaluating the liquidity of the company’s assets. The greater the resulting ratios, the more liquid the company is.
- Debt/Worth Ratio
Also termed as leverage ratio, the debt/worth ratio demonstrates the solvency of a business. The resulting ratio will determine the business’ assets and liabilities. In mathematical terms,
Debt/Worth Ratio = Total Liabilities / Net Worth
Limitations of a Balance Sheet
- The balance sheet cannot describe the gains or expenditures incurred or made by the company over time.
The market worth of assets, its quality, contingent liabilities, and operating obligations are not reflected on the balance sheet.