Whereas Profit and Loss Account (P&L Account) covers the whole financial year, Balance Sheet is a statement of the estimated value of the company at one moment in time – usually at the end of the quarter or at the end of financial year.
The information contained in Balance Sheet can be used in a number of ways.
Advantages of Balance Sheet
- Shows financial position of the business. Balance Sheet depicts the financial position of the business on a particular date. Business stakeholders can also see the difference of position in the current reporting period compared to Balance Sheets in previous reporting periods. It can be used to measure business’s financial status over time. Ratio Analysis is used for this kind of detailed business analysis.
- Helps to determine risk vs. return. Prospective investors will assess the level of assets, liabilities and equity before investing their money into a firm. They want to know how wealthy and stable the business is, hence want to determine how risky their investment will be. Therefore, Balance Sheet can help to attract prospective investors. The better the Balance Sheet the firm has, the better the prospects of getting higher funding. Investors will analyze Balance Sheets of many businesses to understand where their money will be invested.
- Can be used to apply for a bank loan. Banks and other lenders usually require Balance Sheet to determine the financial health and creditworthiness of the business. The ability of a business to repay loans is directly related to the quality of its Balance Sheet. So, lenders want to know how and whether they will be repaid.
However, there are several limitations to Balance Sheet. Let’s check them out as well.
Disadvantages of Balance Sheet
- Static. Balance Sheet is a static document. It means that it shows the financial position of the business as of the date when the document was published. This might be very different in subsequent periods in the future, or even tomorrow.
- No standardized format. The content of Balance Sheet is decided by specific regulatory bodies in each country. There is no universal format required for producing Balance Sheet. It means that accountants will produce Final Accounts in varying formats and include different assets and liabilities depending where the business is located. This makes it difficult to make comparisons of different firms, even those operating in the same sector of the economy.
- Book value is often different than market value. The real market value of Fixed Assets such as land and buildings is only known once those items have been sold. And, if the business uses funds from the capital and reserves for expansion, then the value of those positions will quickly change as well. Therefore, the book values from Balance Sheet do not necessarily match the market values of assets as valuations of Fixed Assets may be different.
- Cannot guarantee future success. The figures in Balance Sheet are only estimations of the value of assets and liabilities. Those values can change the next day as real estate prices fluctuate. Therefore, the business might be worth less in the future than what has been assumed in Balance Sheet. For this reason, Balance Sheet is not a reliable measure of how much a business is worth.
- Not all assets are included in Balance Sheet. A detailed breakdown of all tangible assets is not shown under Fixed Assets, so the information is somewhat incomplete. In addition, many intangible assets such as skills of workforce or quality of managers cannot be measured quantitatively, hence this information is not included. It would be very difficult to determine accurate valuation of each employee in the firm.
- Differences between Balance Sheets of different types of businesses. Balance Sheets produced by incorporated businesses such as Private Limited Companies and Public Limited Companies will be quite different from Balance Sheets produced by unincorporated businesses such as sole traders and partnerships. For example, while limited companies can raise finance through the sale of shares, whereas this would not appear on the balance sheet of unincorporated businesses. Also, unincorporated firms do not have shareholders, so shareholders’ funds are replaced with owner’s equity including the personal funds of sole traders and partners. Unincorporated firms do not pay dividends to shareholders, so dividends will not appear under Current Liabilities. Instead, sole traders or partners will take out funds from the business for their personal use.
In short, Balance Sheet shows the financial position of a business at a certain point in time. Mainly, what the business owns and how did the business pay for what it owns. Clearly, Balance Sheet will shed lights on the value of the business and whether it is a wealthy well-run prosperous business, or a lousy highly-leveraged sinking boat.
