What is the purpose of a balance sheet? Our best guide

By Nguyen Oanh
Published: 10/29/21
definition backgroundWhat is the purpose of a balance sheet? Our best guide

The balance sheet is one of the key accounting documents that make up the annual financial accounts of your company. The balance sheet shows the assets of the company at a given section in its existence (usually at the end of the financial year).

More precisely, it includes what the company owns (balance sheet assets) and what the company owes (balance sheet liabilities). Ultimately, the balance sheet reflects the financial policy of the company.

In this article, we will explain what is a balance sheet, its purpose, and its main elements, as well as some examples of balance sheets to help you establish a balance sheet for your business.

What is a balance sheet?

The balance sheet is part of the financial statements that make up the annual financial accounts of your business (with the income statement). The balance sheet provides the information of the company's assets at a given time, generally at the end of the financial year even if the table can be drawn up at any time to take a look at what the company owns and what that it owes (its claims and its debts). It is said that the balance sheet is a "financial snapshot of the company at a given time".

The balance sheet uses the form of a table included two columns:

  • The left column includes the assets of the company (what it owns);
  • The right column includes the company's liabilities (what it owes).

The main elements of the balance sheet

As mentioned above, this financial statement includes 2 important values:

Assets

The items of assets (left column in the balance sheet) are the items that constitute the heritage of the company.

They are ordered from top to bottom, from the most stable point to the most liquid point:

  • Goods acquired to be used in a sustainable way (it includes constructions, materials, business assets, licenses, software, etc.);
  • The most liquid items included goods that can easily be converted into money/cash, such as miscellaneous cash (current assets).

Note that goods financed by leasing are not included in this item because they are "rented" and not purchased by the company.

Liabilities

Liabilities (right column in the balance sheet) include all the resources the company has at its disposal to finance its assets.

  • Equity: includes the funds/cash that the business owner (or the partners) leaves at the disposal of the company, in particular, the funds of the company or the contributions of the operator, increased by the results not collected by the latter or not distributed to the partners (investors, shareholders, …). Equity includes 2 types: Book value and Market value.


    Equity, as a stable resource of the company, makes it possible to finance investments. The greater the amount of equity in a company, the more reassured suppliers, customers, and potential investors will be about the longevity of the company.

    Equity = Assets - liabilities

  • Corporate debts: namely those vis-à-vis suppliers, but also vis-à-vis the State, staff, and social organizations.

  • Financial Debts: are the sums due to credit organizations that participate in the financing of the company's assets

The value of equity actually represents a debt for the company since it will be used to remunerate the partners (in the long term).

Purpose of balance sheet

Reading the balance sheet allows you to know the state of financial health and the financial policy of the company.

For example, a very high level of stock on the asset side of the balance sheet (in particular compared to the average data on the activity sector concerned) may show a management dysfunction (why are the products not sold?), without forgetting to think that a stock kept too long depreciates over time.

A high level of trade receivables on the asset side of the balance sheet can show a failure in the company's customer care (why don't customers pay at the time of sale?). This shortfall must also be offset by a provision for risk in the liabilities of the balance sheet.

Some financial management ratios are calculated from data from the balance sheet. They allow the leader to know the state of the company's financial situation and to make informed business decisions on a daily basis.

  • The debt ratio: shows the degree of financial dependence of the company on its investors

    The debt ratio = financial debt / equity
  • Working capital: shows the company's availability to cover its business cycle and longer-term financial investments


    Working capital = (equity / medium and long-term borrowed capital) / fixed assets = current assets - current liabilities

  • The working capital requirement: shows the liquidity required to finance the business cycle and particularly the cash flow mismatches

    WCR = (stock + trade receivables) - trade payables, tax and social security debts

In other words, the balance sheet serves as a strategic tool for analysis and activity management. Not only is it an annual obligation for most companies, but it will be very useful to you in front of administrations and in front of banks to justify the solvency or cash resource of your company and its financial health, in particular if you wish to contract a loan.

Examples of a balance sheet

example of balance sheetExamples of a balance sheet

Tips to evaluate the results of the balance sheet

The company must constantly ensure that all the cash resources at its disposal are used as best as possible while respecting that:

  • an asset whose possession must be durable and secure (eg: fixed assets) is invested by a durable money source (eg: loans),

  • an asset linked to the business cycle is invested by resources from this same business cycle (eg: supplier credit).

In practice, we very rarely find this perfect balance and we, therefore, observe the following situations:

  • Durable funds exceed durable goods: The work tool is properly funded. The situation is healthy and comfortable a priori.

  • Stable cash is lower than stable assets to be financed: The financing of the work tool has not been correctly understood in amount or in duration. This anomaly leaves a weakness hanging over the company that will have to be corrected.

  • Resources from exploitation are greater than jobs: The company has excess funding. This situation is frequent for service activities where the services sold are collected immediately while salaries and social charges are paid at the end of the month.

  • Jobs linked to the business cycle exceed cash: There is a need for financing, called a working capital requirement. This can come from abnormally high merchandise compared to the due supplier, which suggests a risk either on the physical inventory (theft, breakage, etc.) or on the conditions of a settlement negotiated with suppliers

The difference between the balance sheet and the income statement: not to be confused!

Be careful, do not confuse the balance sheet (statement of the assets and financial health of the company at a given time) with the income statement or cash flow statement.

The balance sheet shows the financial result of the company during a given period (usually the financial year). The income statement shows more exactly the collections that were made during the year as well as all charges and expenses incurred.

The result of the income statement is a profit or a deficit while with the balance sheet, the assets have to be equal to the liabilities. The income statement does not highlight any cash flow mismatches.

Note that the income statement and the balance sheet are among the main elements of the company's annual financial accounts.

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