Balance Sheet Purpose

The main purpose of the Balance sheet is to understand its users about the business's financial position at a particular point in time by showing the details of the assets of the company along with its liabilities and owner's capital.

The purpose of preparing the Balance Sheet is to provide the company's financial status at any specific point in time to multiple stakeholders or potential stakeholders (management, shareholders, lenders, creditors).

• The Balance sheet is of great utility for internal, external, and potential stakeholders/investors.
• The Balance Sheet of any organization generally provides details about debt funding availed by the Organization, Use of debt and equity, Asset Creation, Net worth of the Company, Current asset/current liability status, cash available, fund availability to support future growth, etc.

• The balance sheet's primary purpose is to provide a snapshot of a company's financial position at a specific time, presenting a summary of its assets, liabilities, and shareholders' equity.
• The primary purpose of the balance sheet is to provide stakeholders, such as investors, creditors, and management, with an understanding of the company's financial health, solvency, and liquidity.
• The balance sheet helps assess the company's ability to meet its short-term and long-term obligations and evaluate its capital structure and financial leverage.
• The balance sheet is a foundation for financial analysis, ratio calculation, and decision-making regarding investments, lending, and overall financial management.

#1 - Management of the Company

source: Colgate SEC Filings

Management of the Company generally requires the details related to the company's debt funding status, liquidity situation assessment, trade receivables  status, cash flow availability, the investment made in other assets, and fund availability for future expansion to plan the future course of activities for the next period. For example, management may decide to reduce the debt from its current level based on balance sheet representation as they feel it's relatively higher than the industry benchmark. In addition, control of the company may take a call on liquidity improvement measures if they think that its working capital cycle is relatively stretched based on the Current asset/current liabilities status on the Balance Sheet. Therefore, the Balance Sheet serves a larger purpose for the Company's Management to identify existing issues, anticipate future problems, and chart out a course correction plan.

#2 - Investors of the Company/Potential Investors

Investors in the Company Use the Balance Sheet, along with other financial statements, to analyze the company's financial soundness. They also use trends of the last few years by analyzing the numbers in a financial statement to understand the company's future growth potential and make a decision to stay invested in the company and increase/decrease the shareholding in the company.

Balance Sheet may also be used by potential investors or Companies looking to acquire businesses or partner with Companies for their expansions.

#3 - Banks/Financial Institutions

A balance sheet serves a critical purpose in deciding whether to lend or not to lend to Banks. As a Balance Sheet gives a stock of existing debt and equity composition and status of current assets and current liabilities, it helps Banks to analyze if the company has already over-borrowed and has limited ability to repay the debt. It also allows lenders to analyze the company's liquidity situation, decide on an amount of working capital/short-term loan, set the drawing power limit against the short-term loan, monitor the loan account, and, most importantly, in decision-making for lending to a Company.

For existing Banks, the Balance Sheet serves a critical purpose of tracking the fund flow and utilization of the already disbursed loan by analyzing the corresponding increase on the asset side. A careful analysis by Banks can help them find if the loan disbursed for a specific purpose is being used for the same purpose or being diverted by the company for something else, which can give an early warning signal for a potential default loan.

That is precisely why bankers stipulate a condition for Companies to furnish their quarterly/annual Balance Sheets promptly.

#4 - Customers/Potential Customers

The Balance Sheet of an Automotive parts manufacturing company, a parts supplier to a Car Manufacturer, is critical. Because a Car Manufacturer would like to establish a relationship with a financially strong and stable company. A Car Manufacturer would not like to face the risk of its suppliers stopping the operations and the supply of parts to the Car Manufacturer, which ultimately affects the operation of the Car Manufacturer. Therefore, in such a situation, the Car Manufacturer will analyze the company's existing debt, current liquidity situation, and fund availability to support future growth to establish the company's financial soundness.

#5 - Raw Material Suppliers/Creditors

The Balance Sheet of the Company helps Suppliers/Creditors understand the company's financial strength. A Company with relatively stronger financials enjoys better trust/comfort /terms from its creditors.

#6 - Government Agencies/Banking Regulators/Stock Market Regulators

Bankers do business with public deposits. Therefore, banking regulators use the Balance Sheet of the Companies to detect any possible malpractices/ fraudulent activities being undertaken by the company in the larger public interest. Similarly, Stock market regulators also keep an eye on the Companies by screening through their financial statements/balance sheets to detect any misdeeds being done by Companies in the larger interest of retail investors in publicly traded companies.

The balance sheet is used for Ratio Analysis as given in the following table-

Liquidity Ratio Analysis

• Current Ratio Analysis
• Quick Ratio Analysis
• Cash Ratio Interpretation

Turnover Ratios

• Receivables Turnover Ratio Analysis
• Inventory Turnover Ratio Analysis
• Accounts Payable Turnover Ratio Analysis
• Cash Conversion Cycle

Operating Efficiency Ratio Analysis

• Asset Turnover Ratio Analysis
• Net Fixed Asset Turnover
• Equity Turnover

Business Risk

• Financial Leverage Analysis
• Total Leverage

Financial Risk

• Leverage Ratio Analysis
• Debt to Equity Ratio Analysis
• Interest Coverage Ratio Interpretation
• Debt Service Coverage Ratio

Other financial ratios, such as profitability ratios and return ratios, can be calculated by using all financial statements (Balance Sheet, P&L Statement, and Cash Flow). Multiple stakeholders may use these ratios, such as Investors, lenders, management, and business partners, to analyze any organization.

• The company's Balance Sheet gives a financial snapshot of the Organization at a specific point in time. The Balance sheet provides details of the company's capital structure, Gearing, liquidity condition, cash availability, asset creation over time, and other company investments.
• It is useful when multiple stakeholders are involved with the company and often becomes a critical part of decision-making by stakeholders.
• Though the Balance Sheet alone has some limitations in providing complete financial health of the Company, the Balance Sheet, along with the Revenue Statement and Cash Flow provides a complete analysis of the organization's financial health.
• It is useful for banking regulators/Share market regulator/retail investors in the case of publicly listed companies.

This has been a guide to the Purpose of Preparing a Balance Sheet. Here we discuss the purpose of the Balance Sheet for various stakeholders, Ratio analyses, and practical examples. You may learn more about Accounting from the following articles –

• Classified Balance Sheet
• Trading Securities
• Balance Sheet of Banks
• Trial Balance vs. Balance Sheet Differences