What is a Balance Sheet? Key Uses and Importance Explained

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28 NOVEMBER, 2024

There are three major financial statements that provide a clear picture of the economic stature of a company. These documents are necessary not only for the smooth functioning of an organisation but also to help create strategies for future goals. The three financial statements are- (i) income statement, (ii) balance sheet, and (iii) cash flow statement.

In this blog, we are going to discuss the balance sheet in detail and its importance in an organisation.

What is a Balance Sheet?

A balance sheet is a crucial financial statement that evaluates a business’s financial state at a particular point in time. It is an essential document for an organisation to manage its finances precisely and have the right information on assets vs. liabilities. If you are a business owner or you need to deal with accounts, understanding the meaning of the balance sheet and its functioning is crucial.

Business owners use this document to calculate return rates for investors and evaluate their capital structure. In short, it summarises what a company owes and owns. It also mentions the investment amount by shareholders. Business owners use this document to analyse the financial fundamentals or calculate ratios.

Understanding the Functioning of Balance Sheets

A balance sheet uses the following formula to calculate a company’s financial metrics:

Assets = Liabilities + Shareholders’ Equity

This is an intuitive formula, as a company must pay for all its assets by borrowing money or raising capital from investors, resulting in liabilities. For instance, if a company borrows a Rs. 5 Lakh loan for five years, its assets increase by Rs. 5 Lakh, but its liabilities also increase by Rs. 5 Lakh. If a company raises Rs. 10 Lakh from investors, its assets and shareholder equity increase by that amount. The company’s revenue generated in excess of the expenses goes into the shareholder equity account.

Important Factors of Balance Sheets

Here are a few important factors to know about balance sheets:

The asset should balance the shareholder equity and liabilities
Imbalanced assets and liabilities indicate problems, like errors in data, exchange rates, and calculations
Each category has smaller accounts indicating a company’s financial specifics
The accounts can vary widely by industry

Key Components of a Balance Sheet

Let’s talk about the two components of the balance sheet:

Assets: Assets include all items a business owns. Any item with a tangible value falls under this category. Based on their liquidity, assets can be divided into two types: current and non-current assets. Cash, inventory, and account receivables form a company's current assets. Conversely, non-current assets have low liquidity. An owner must wait to convert them into cash.
Liabilities: Liabilities include anything that a business owes to its debtors. Like assets, liabilities are of two types: current and non-current. Current liabilities include a company's obligations within the following year. On the other hand, non-current liabilities include a company’s long-term debt, such as loans.

Limitations of a Balance Sheet

Although it is crucial for investors, accountants, and analysts, a balance sheet also has some limitations, including the following:

The sheet only shows a company’s financial metric at a particular time. It cannot predict its future performance
The document has a static structure. You must also analyse the income and cash flow statements to understand a company's financial health better
Managers adjust the numbers to make the business appear more profitable, leading to corruption

Importance of a Balance Sheet

A definition of a balance sheet is essential, as it helps to understand a company’s performance. Here are a few reasons why it is necessary:

It helps assess a company’s financial health
Allows stakeholders to understand a company’s business performance and liquidity position
Strengthens a company’s Business Loan application
Comparing the past balance sheets helps determine a company’s growth over the years
It helps understand a firm’s ability to handle urgent expenses or undertake expansion projects
Identifies a company’s source of funding, including debt or equity funding

Example of a Balance Sheet

Here is a sample balance sheet format often used by businesses:

Company Name
Balance Sheet as on XX/XX/XX
Particulars	Note Number	Figures at the end of the current reporting period	Figures at the end of the previous reporting period
Equity and Liabilities		Rs. X	Rs. X
Share Capital		Rs. X	Rs. X
Reserves and Surplus		Rs. X	Rs. X
Long-Term Loans		Rs. X	Rs. X
Trade Payables		Rs. X	Rs. X
Tax Liabilities		Rs. X	Rs. X
Total

Assets
Inventories		Rs. X	Rs. X
Current Investments		Rs. X	Rs. X
Cash And Cash Equivalents		Rs. X	Rs. X
Trade Receivables		Rs. X	Rs. X
Capital Work-In-Progress		Rs. X	Rs. X
Net Deferred Tax Assets		Rs. X	Rs. X
Long-Term Loans And Advances		Rs. X	Rs. X
Total

How to Create a Balance Sheet

Follow these steps to create the document on a set balance sheet format:

Determine the date for preparing the sheet
List all assets and categorise them into current and non-current assets
Add up the value of all assets to determine the total amount
List all liabilities and categorise them into current and non-current liabilities
Add up the value of all liabilities to determine the total amount
Deduct the value of total liabilities from total assets to calculate the equity value
Organise the data by putting assets on one side and liabilities and equity on the other side of the balance sheet format
Review and analyse the sheet to ensure it is complete and accurate
Evaluate the results to determine a company’s financial health