What Is the Function of a Balance Sheet?
A balance sheet is a snapshot of the assets a company owns, the debts it owes, and how much it is worth. The importance of a balance sheet is that it serves as one of the tools management, lenders, and investors use to assess a company’s overall situation. It is not hard to understand a balance sheet, but you need to know how the parts of a balance sheet function and the role it plays in providing a complete picture of the company.
The function of a balance sheet is to demonstrate the company's financial status — including assets, liabilities and equity — at a specific point in time.
A balance sheet summarizes a company’s financial condition at a particular time. It consists of three main parts.
A listing of the company’s assets is placed at the top. This is followed by a similar list of the company’s liabilities. Equity (or shareholders’ equity) is placed at the bottom. Equity is calculated by subtracting the total liabilities from the total assets (thus, total assets always equal total liabilities + equity). A section with explanatory notes may be included.
Most companies prepare a formal balance sheet once a year and include it in their annual report. The amounts from the previous year are frequently listed alongside the current figures for purposes of comparison. This formal balance sheet should be reviewed by an independent auditor to verify its accuracy and completeness.
Occasionally you will run across an interim or partial balance sheet. These function the same way and are often prepared as an internal document company management uses to assess particular issues.
Each section lists the relevant information by category. Asset categories include accounts receivable, cash and cash equivalents, fixed assets (land, buildings, equipment, etc.), inventory and so on. If a company has invested money in projects to improve its reputation and relationship to a community, this may be listed as an intangible asset.
Categories may be broken down further; under cash and cash equivalents you might see entries such as petty cash and money market funds. The Liabilities section will be structured the same way, listing accounts payable and bonds, and short term debts.
The function of a balance sheet is to help you evaluate a company’s financial status. Ask yourself questions about the items listed. Investors pay particular attention to liabilities. Too large a proportion of debt can indicate a company is overextended and might not be able to meet its obligations in the event of a business downturn.
The type of debt is important as well. Long term debts (such as bonds with 20- or 30-year maturities) are preferable since they entail less cash outlay in the near future.
A balance sheet functions best when you place it in context with other information, such as past performance, sales, market share and plans for the future. For example, if inventory levels have risen from the previous year faster than revenues, this may indicate some of the company’s products are not selling well. Take advantage of the explanatory notes included with the balance sheet — they can address concerns or alert you to potential problems that may not be obvious at first glance.