Principles of Accounting: Importance of the Balance Sheet

Financial statements
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Introduction
In every business setup, there is always the need of recording all transaction that takes place during a financial year. This records play a major role in determining whether the business is making a profit or not, show the flow of capital in the business and they also indicate the net worth of the business. There are three basic financial statements which include statement of financial position, the income statement, and statement of cash flow. Each of the three statements plays an important role in recording the company finances. Information found on one statement can be found in another statement under a different name. The statement of cash flow is always prepared after we have acquired the net income while the balance sheet preparation starts when we know the amount of cash available both at a bank and in hand. In preparation of the income statement and balance sheet, we mainly use the balance sheet equation and double entry rule respectively. For our analysis, we are going to discuss each statement indicating all the major role they play in the business financials and how they interact with one another.
Analysis
Balance sheet
Meaning
A balance sheet is also referred to as a statement of financial position. It is a financial statement that shows a company’s assets, liabilities and shareholder’s equity at the end of a financial period. The assets usually indicate what the company owns while the liabilities shows what the company owes. Shareholder’s equity shows the amount invested by shareholders. A balance sheet always follows the formula, total assets= total liabilities + shareholder’s equity. The statement of financial position is commonly referred to as a balance sheet since assets must always balance out with liabilities and shareholder’s equity. This mainly indicates that a company must pay for what it owns either by borrowing money from financial institutions or issuing shares that bring in shareholder’s equity. A balance sheet also indicates the amount of cash in hand which will be reflected in the income statement as net profits if the owners of the company do not invest or withdraw capital from the company.
Importance
Apart from showing what the company owns and owes, a balance sheet is also used to calculate the percentage of assets acquired through debt. This is achieved by calculating the debt to asset ratio. The other financial ratios calculated using entries on the balance sheet include:
* The current ratio which is used to determine a company's ability to pay its liability using its assets. This is an example of a liquidity ratio.
* Quick ratio which is used to measure a number of liquid assets available for each dollar of current liabilities
* Leverage ratios: This ratio generally measures the value of the company's equity by first checking the overall debt. They include debt to equity ratio and debt to asset ratio.
These financial ratios are also useful in comparing the company ratios with the industrial ratios to determine the performance of the company in the industry. A balance sheet also helps the owners of a company to understand the financial strength and capabilities of their company. It is also useful in the calculation of working capital (current assets- current liabilities). If we have the balance sheet record of up to three years, we are able to determine whether the receivable collection cycle is widening. This implies that we are able to determine the amount of time the company takes to collect its receivables and it also helps determine which debt is unrecoverable. A balance sheet could also be used by both the company owners and financial lenders to determine the creditworthiness of the business from time to time.
Income statement
Meaning
This is a financial statement that shows the financial performance of a company over the financial period. Financial performance is determined by first knowing how the company gets its revenue and a number of expenses incurred in both operating and non-operating activities. It is also used to determine the amount of net profit or loss. Income statements give performance information about a period of time. The first entries to an income statement calculate the net sales then we work down until we obtain our net income and earnings per share. An income statement is usually divided into two part. The operating part shows revenue and expenses that are as a result of regular business operations. The non-operating part indicates revenue and expenses that are not generated through the company’s regular operations.
Importance
An income statement can be used to generate profitability ratios such as return on equity which is used to determine the amount profit generate from shareholder’s equity. Earnings before interest tax and amortization which indicates the company’s profit excluding tax and interest. Return on assets and operating profit which indicates how well the company is employing its total assets to make profits. Each item on an income statement is presented as a percentage of sales. This makes it easier to determine which expenses make up the largest portion of sales. An income statement can also be used to compare ...