Balance Sheet Analysis
An analysis of the balance sheet items helps to answer some major managerial questions such as: How can the firm increase its net assets and owners’ equity? What may cause decrease in net assets and owners’ equity? What happens to net assets and owners’ equity if assets or liabilities or both increase of decrease? Such an analysis will provide a critical insight into the meaning of various balance sheet items. It can help to understand the cause of changes occurring from one period to another in balance sheet. As stated, balance sheet does not reflect changes in financial position; it contains information at a specific date. Thus, this statement (balance sheet) is static in nature. Another statement, the statement of changes in financial position, may be prepared to reflect the changes in assets and liabilities.
The balance sheet reflects the financial position of the firm. Like any other statement, the balance sheet should contain a heading. The heading includes the name of the firm, the type of statement and the date to which the statement applies. The balance sheet must carry a specific date, such 31st December, 2011. The assets, liabilities and owners’ equity are relevant only for the date specified. The balance sheet can be presented in the account form or the report form. The balance sheet has two sides. The right-hand side lists the various assets of the company and the left-hand side shows the means by which assets have been financed; that is , liabilities and owners’ equity. Left-hand side gives the details of the sources of borrowed funds and owners’ original investment plus reserves and surplus. It should be noted that the totals of two sides are equal. This necessarily follows from the accounting equation, TA = TL + OE and does not indicate anything about the firm’s financial strength. The use of the term balance sheet does not convey anything very special, as the two sides must always balance. In the report form, a step-wise balance sheet is prepared, listing assets at the top and then listing liabilities and owners’ equity.
The report-form balance sheet reveals the concept of net current asset. In practice, companies show their summarized balance sheets in the report-form. They divide balance sheet into two parts: (1) sources of funds, and (2) application of funds. Sources of funds include shareholders’ funds (net worth) and borrowing divided as secured and unsecured. Application of funds include net fixed assets (net block plus other non current assets) and net current assets (difference between current assets and current liabilities).
Balance Sheet Functions
The three important functions served by the balance sheet are:
- It gives a concise summary of the firm’s resources (assets) and obligations (liabilities and owners’ equity).
- It is a measure of the firm’s liquidity.
- It is a measure of the firm’s solvency.
Stewardship Role — In the definition of accounting we noted that it has a custodial, or stewardship role to play. The balance sheet fulfills this function. It reports to owners and others the state of the firm’s affairs — assets owned by the firm and the claims against them.
Liquidity — The balance sheet also contains information about the firm’s liquidity position. Liquidity refers to the firm’s ability to pay debts as they mature. The net current assets is the measure of the firm’s liquidity. This information is directly given in the report-form balance sheet and can be computed in the account-form balance sheet. The liquidity position of the firm is of particular interest to creditors. The greater will be their risk if the liquidity position of the firm is weak.
Solvency — The balance sheet also indicates the solvency of the firm. Solvency refers to the firm’s ability to meet eventually all of its long-and short-term debts. A high proportion of debt can endanger the firm’s solvency. If functions of the balance sheet are examined in terms of the basic accounting functions, then the balance sheet,
- Accumulated information in conformity with the basic accounting equation TA = TL + OE;
- Measures assets and liabilities in monetary units and in accordance with cost principles;
- Communicate information about assets (resources), liabilities (outside claims) and owners’ equity (residual claim of owners) to owners, creditors and others.