April 25, 2020
The balance sheet is a financial tool used by corporations, business proprietors, individuals and shareholders to track the financial position of the business. It is among the most important statements of accounts and shows how much the business is worth as at a specified period of time, usually the end of the financial year. I agree with the statement that the balance sheet shows how much a business is worth. The balance sheet reveals how much a business owns, how much it owes others and the amount of capital invested in the company by the investors. The difference between what the company owes and owns gives the net worth of business.
To understand how the balance shows the net worth of the company, it is important to understand the components of the balance sheet. The balance sheet has two major components, the assets components and the liabilities components. The assets component represents the items, things and properties that the business owns. They are items owned through transactions and an economic value can be put on them in the future. They are items that have monetary value. The assets are divided into different categories. First, the fixed assets like land, furniture, motor vehicles and buildings. Secondly, the intangible assets like investments and goodwill. Thirdly, the current assets like the debtors, prepayments, stock, cash and bank. The assets are usually drawn on the left hand side of the balance sheet while using the horizontal format or as the first part when using the vertical format of a balance sheet (Ramachandran & Kakani, 2009).
The liabilities component represents the items the company owes others. The liabilities could be short-term like bank overdrafts, liabilities, and payables or long-term like bank loans and other loans payable for a period over one year. The company has the obligation of paying the liabilities first before paying the investors their profits and earnings. The liabilities are drawn on the right hand side of the balance sheet when using the horizontal format or as the second part while using the vertical format of a balance sheet.
The balance sheet shows how much the investors or shareholders have put into the company. This is determined by taking the difference between the company’s assets and liabilities. A list of assets is made and values put on them and another list of liabilities is made and a value put on them. Then the difference between them is determined. The difference between the assets and liabilities represent the net worth of the investors. The net worth of the business is the amount left after paying all the obligations and liabilities the company owes to others. Thus, a balance sheet shows the net worth of a business or a company.
The balance shows what the business owns, what it owes to others and the shareholders worth in the company. It is prepared every year and the comparison between the current and the previous is used to determine the net worth of the company. The increase in assets over the years shows that the company has improved its net worth while the reduction in the assets shows that the company’s net worth has declined. Alternatively, an increase in the number of liabilities indicates that a company’s net worth is declining since it owes more to others. When the liabilities decline over the years, the company’s financial position improves as the company owes fewer amounts to other people (Browne, 2010).
The balance sheet records the fixed assets in its historical value less any amortizations and depreciations. This shows the amount the assets can fetch if it were to be sold today. This shows the exact value of the assets today and therefore, the balance sheet can be used to determine the value of the total fixed assets. These are assets owned by the shareholders of the company and are used to generate income. The value of the assets then represents the value of the shareholders in the company.
The balance sheet shows the company’s liquidity level. It shows the assets the company can convert to cash in the event that the company faces liquidity problems. For instance, investments, debtors, and stock. In the event that the company is facing financial problems, the management turns to the balance sheet and sells off some of these assets to get money to pay its obligations in the short term. This shows that the company uses the balance as a reference to what it owns and what it can convert to cash without incurring more liabilities.
The balance sheet can be used to show what a company owns even though the company does not have it in its possession. For instance, in cases of debtors and prepayments. When a company makes prepayments for certain goods or services, it only means that the company has paid for the goods or services it has not received. This means that the company can recall the payments and convert them into cash or other assets. When a company sells goods on credit, then the balance sheet helps the company to know how much other people owe the company. This is equivalent to what to what the company owns and forms part of the net worth of the company (Folsom, & Boulware, 2004).
The net worth of investors changes over time as the balance items changes. The profits recorded in the income statement are transferred to the balance sheet as the profits for the year. The business uses the profits to reduce the amount of the liabilities which results to an increase in the net worth of business. In addition, when the profits are used to acquire additional assets, the net worth of the business increases given that the liabilities do not change. When the value of the assets in the balance sheet reduces, then the net worth of the business reduces. When assets increase through loan finances, the net worth remains constant. This means that the balance sheet determines the net worth of the business to a great extent.
The balance sheet has a section of retained earning under the long term liabilities section of the balance sheet. The retained earnings represent the amount of profits retained in the company for more investments. The retained earnings can also be used to repay dividends to shareholders. An increase in retained profits over the year’s show that the company is doing well and the net worth of the shareholders is improving over time. This means that we can use the balance sheet to determine whether the net worth of shareholders is improving over time or not.
The balance sheet can be used to determine the solvency situation of a company. When the company’s liabilities exceed the company’s assets, then the company has a negative net worth. In such a case, the company is declared bankrupt or insolvent. This means that the company cannot be able to pay its financial obligations as it does not have enough assets to do so. However, when the company’s assets exceed the company’s liabilities, the company is said to be solvent and it has the ability to pay its obligations as and when they fall due. In such a case, the company is said to have a positive net worth.
The balance sheet also present data essential to determine the financial stability of a business. The balance sheet items are used to calculate ratios that show the financial performance of a business. Examples of these ratios include, the gearing ratios, current assets ratios, return on investments ratios, and return on assets rations. These are important ratios used in determining the financial performance of the business and hence, the net worth (Engle, 2010).
Conclusively, the balance sheet together with other statements of accounts forms the basis for investors to have an insight into the performance of the company. The balance sheet gives the investors a snapshot into the current financial position of a company. This is because the balance sheet provides a summary of what the business owns (assets) and owes other businesses or individuals (liabilities). Detailed comparison of the assets and liabilities results to the financial position of the company and consequently the net worth of business. The balance sheet gives all stakeholders an overview of whether the business is able to meet its obligations or not.
The lending institution uses the balance sheet to determine the leverage level of the firm by looking at the long-term liabilities. This determines whether the institutions will lend more money or not. Creditors look at the balance to determine whether the company has enough liquidity to repay their obligations. The investors, on the other hand, look at the balance sheet to determine whether the company has enough assets to repay their investments. From the discussion above, it is therefore clear that the balance sheet shows the net worth of business.
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