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 capabiliti...