The Importance of a Balance Sheet - Essay Example

Introduction Balance sheet constitutes a vital part of a company's final accounts that provides valuable information to internal and external users of financial statements. A balance sheet can be produced and presented on an annual or periodic basis. Balance sheet is not used as source of information related to day-to-day transactions. A strong balance sheet strengthens the investor's confidence in the company and motivates to invest more because investors can see huge returns for future in the form of dividends and bonus. The balance sheet further makes it easier for the financial manager to take wise decisions and know the reasons behind non-accomplishment of company's goal. It can also help managers to establish policies and strategies for the future. This paper provides information about the importance of balance sheet and its uses for investors and management. It also provides an insight into the ratio analysis that could be done on the basis of information obtained from balance sheet. The paper shows calculation and analysis of ratios from the balance sheet of Palaron Plc so as to understand the usefulness of information presented in the balance sheet for investors. The importance of Balance Sheet Balance sheet plays a vital role in depicting the financial position of a company. It further shows whether an investor should invest in a particular company or not. A company's balance sheet also shows the strengths and weaknesses of a company. A company through its balance sheet portrays its financial position to the investors that it is a reliable company that possesses prosperous prospect and chances to grow. It also reflects whatever the goals have been set by the company will definitely be accomplished and delivered to the investors in the shape of cash or stock dividends. Birts also says that "the company must demonstrate its ability to trade for some time into future so that customers have confidence that it will be able to meet its commitments to them" (2001, p36). Investors would learn from the balance sheet a company's long-term investments, capital structure, liquidity and gearing position so as to analyse if the company would be able to remain in business for a longer period of time. The balance sheet at the end of the year demonstrates the total assets and liabilities made by the company. There are two types of assets; current assets and fixed assets. Current assets include all the assets that are for less than one year i.e. cash, accounts receivable (with deduction of bad debts expenses), notes receivable, prepaid expenses incurred and merchandise inventory where as fixed assets include all those fixed assets which can transcend for more than one year i.e. machinery, equipment, land, building and plant assets etc. The depreciation and amortization are deducted from these fixed assets. Liabilities are also of two types; current liabilities and non current liabilities. Current liabilities include debt which is payable in year i.e. accounts payable, notes payable, accrued expenses and insurance premium etc while long term liabilities includes bonds payable etc. These are not enough because for a complete balance sheet it also includes owner's equity which includes total invested capital and retained earnings. The balance sheet is not only essential for the investors but also to large extent to the company itself. It gives the financial conditions of a company that where it stands at a particular time and show the real minus and plus points. In order to get the things on credit or need some credit to invest in the business to earn amplify potential gains, balance sheet items i.e. powerful fixed and current assets would help in getting the credit (Birts, 2001). With the help of balance sheet it becomes easier for a company to make decisions and prepare the plans for future and it can also know about the reason of being unsuccessful in the business, it further gives a complete outlook of the company progress which helps a company to get rid of barriers and obstacles in the way of achieving its goal. The asset portion of the firm is crucial for investors in order to analyse what the company is worth and how long it plans to retain investment. A company's liquidity position indicates the future threats of bankruptcy associated with any company. Balance sheet reveals the cash position of a company that it has a potential to bear minor losses and fluctuations in the market and survive in the tough conditions. Cash is one the most prominent part of balance sheet because it fulfils the immediate needs and helps a company meet its day to day expenditures and pay off its short term debt. Balance sheet also displays the short and long term liabilities of a company. The difference between the total assets and total liability constitute the value of a company (Making Sense of Financial Statements, 02.03.07). The liabilities portion of balance sheet introduces to users the company's position with respect to short and long term debt which suggest whether or not the company is nearing bankruptcy. Companies with high liabilities have high risk for bankruptcy and thus this portion reflects the potency of a company for investors as well as creditors. Liabilities and Equities potions reveal the sources of finance utilised by the company and its capital structure that are of interest also to investors as well as creditors. Ratio Analysis Ratios Analysis plays an essential in determining the actual position of a company further it is one the best method to gauge the performance and functions. Ratio analysis allows a company to judge its business statistics among various criteria. Basically ratio analysis is a technique through which figures in balance sheet can be measured and examined. The data and material extracted from balance sheet is used in ratios which help the investors take wise decisions regarding their investment in a particular company. As a part from company management is concerned the ratios are useful as well because it informs about the company weaknesses and strength and to establish policies for future. The ratios do not tell about the daily operations but give the detail about the historical events that may be useful for a company to take immediate steps and makes easier to rectify problem. The following ratios have been calculated from the balance sheet of Palaron Plc. An analysis of these ratios has also been presented so as to understand what they tell about the company. Liquidity Ratios Liquidity ratios are mainly of interest to short term creditors of the company. The evaluation of a company's liquidity is important for the short-term creditors and lenders of the company in order to make sure that the company is able to pay off its short term debts and expenses (Riahi-Belkaoui, 1998). Most common liquidity ratios are current ratio and quick ratio. An analysis of Palaron Plc's current and quick ratios is presented below: Current Ratio The current ratio gauges a company's capability to pay off its short terms debts and expenses (Meigs & Meigs, 1993). Current ratio for Palaron Plc is 1.19:1 (see appendix), which shows that the company has 1.19 of current assets against every single pound of current liabilities. This shows that the company has enough current assets to meet its short term liabilities, however once the company pays them off, it will not be left with enough liquid assets to finance its activities. Quick Ratio The quick ratio illuminates a company's capability to pay off its short term liabilities and expenses after keeping aside stock from current assets (Mcmenamin Jim, 1999). The quick ratio for the company is 0.82:1 (see appendix), which shows that if stock is separated from current assets, the company will only be able to meet about 80% of its short term liabilities. This is not a healthy condition for the company's liquidity and might be alarming for creditors. Solvency Ratios Debt Ratio Debt ratio shows the percentage of a company's total assets financed with debt capital. Palaron Plc's debt ratio suggests that the company has financed 70.72% (see appendix) of its total assets to finance its total assets. This shows that the company uses more debt finance to provide funding for its operations. Gearing Ratio The gearing ratio reveals the capital structure of a company. It shows the percentage of debt over equity financing. Palaron Plc's capital structure comprises 78.74% (see appendix) of debt and the rest is held by equity financing. It shows that the company uses more debt finance than equity funding. Conclusion This paper illuminates the importance of balance sheet from the point of view of both investors and management. However, it is noticeable that balance sheet happens to be more important source of information for the investors rather than the management. This paper also elaborates the usefulness of ratio and its analysis. The ratio have been calculated and analysed for Palaron PLC using the company's balance sheet. The data for ratio analysis extracted from balance sheet provide in-depth information about the company's financial standing and future prospects. To conclude, it can be said that balance sheet provides valuable information to investors in order to help them with decision making. References Ahmed Riahi-Belkaoui (1998), "Financial Analysis and the Predictability of Important Economic Events", Quorum Books Birts, A. N. (2001). Balances Sheet Structures. Woodhead Publishing England "Making Sense of Financial Statements", All Business, 2 March 2007 http://www.allbusiness.com/accounting-reporting/reports-statements/1307-1.html Meigs & Meigs (1993), "Accounting: The Basis For Business Decision Making", Mc Graw Hill: New York Mcmenamin Jim (1999), "Financial Management: An Introduction", Routledge, London APPENDIX Calculation of Ratios Current Ratio Current Assets = 7,296 Current Liabilities 6,137 = 1.19:1 Acid Test (Or Quick) Ratio Current Assets- Stock = 5,024 Current Liabilities 6,137 = 0.82:1 Debt Ratio Total Debt Finance *100 = 7,022 Total Assets (Fixed + Current) 9,929 = 70.72% Gearing Ratio Total Debt *100 = 7,022 Total Shareholders' equity 8,917 = 78.74% Read More