Usefulness of the Balance Sheet:
1. Provides information about the resources owned by a firm, owners’ funds and the outside liabilities.
2. Helps in the predicting the amounts, timing and uncertainty of the future cash flows.
3. Provides information on a firm’s liquidity, solvency and financial flexibility.
a. Liquidity relates to the short-term financial soundness of a business, i.e., ability of a firm to meet the short-term obligations. It is tested by comparing the current assets (the cash realizations in the near future) with the current liabilities (the payments to be made in the near future). Stockholders also use this ratio to determine if the firm has enough liquid funds either to pay dividends to buy back shares.
b. Solvency refers to the long-term financial soundness of a firm, i.e., does the company have enough assets to pay its long term debts as they fall due? Generally, if the ratio of long-term debts to the owners’ equity is too high it indicates that the burden of future principal and interest repayments is likely to be high.
c. Financial flexibility refers to the ability of a firm to use its cash flows to respond to unexpected needs and opportunities. It is a function of liquidity and solvency. The higher the level of liquidity and solvency the greater the ability of a firm to survive financial setbacks or to take advantage of any profitable investment opportunities.
That many of the airlines like Northwest and US Airways filed for bankruptcy after the Sept.11, 2001 attack indicates that they were experiencing low levels of financial flexibility as was evident from their financial statements.
Limitations of the Balance Sheet:
1. Most assets are reported at historical cost which makes the statements more reliable but less relevant since they are not updated to current values.
2. The use of judgments and estimates to report items like anticipated bad debts, estimated useful life of an asset, pension liability, etc. gives room for earnings management and makes the statements less reliable.
3. Assets of considerable value like technological know-how, market dominance or skillful employees are not reported in the balance sheet since it is hard estimate their financial value.
Therefore or otherwise, the book value (assets minus liabilities) of a business may not reflect its market value (numbers of shares outstanding times the market value per shares). For example, the market value of IBM was 9 times its book value in 2009 (also attributable to their expensing of all R&D expenditure).
Classification in the Balance Sheet:
There are three main elements of a balance sheet:
1. Assets: Resources owned by the business that are capable of giving future economic benefits.
2. Liabilities: Amounts owed to outsiders (probable future sacrifices of economic benefits) like suppliers, banks, bondholders.
3. Shareholders’ Equity: Represents the owners’ investment into the business. It is made up of the invested capital and the earned capital.
In order to make the balance sheet more informative and useful to its users, the assets and liabilities in the balance sheet are classified under the following categories:
Property, plant and equipment
Liabilities and Owner’s Equity:
Current Assets are the assets that are likely to be consumed or converted into cash either within a year or within the operating cycle of business, whichever is longer. The operating cycle refers to the amount of time it takes, on average, for a business to convert its purchase payments (or investments in inventory) into sales receipts. The cycle goes through cash through inventory, production of finished