Why to prepare Balance Sheet or (Statement of Assets & Liabilities)?
The idea of preparing Balance Sheet is to summarize business assets, liabilities and owner’s equity (net worth) at a particular point of time. The Balance Sheet, together with income statement and cash flow statement make up a financial model for the purpose of decision making. Now the question is, “What purpose will a Balance Sheet serve?” The importance of preparing it can be understood from the following:
- Facilitates proper and full disclosure of assets and liabilities
- Helps in ascertaining the financial position of the business by showing assets and liabilities of the business on a specific date
- Discloses the proprietary interest of owner and the solvency of business
- Helps to ascertain the amount of capital employed (Net worth) in business
- Facilitates comparison of assets and liabilities of business on different dates to check deviations
- It helps in ratio analysis for better management of business.
- The balance sheet is a part of the annual report and other documents released by the company and is used to ensure that the business is complying by the laws, tax rules
How to create a Balance Sheet (Steps involved in the preparation of Balance Sheet)?
Balance Sheet is broadly classified into two heads, namely “Assets” and “Liabilities”. As the names suggest, assets are what a business uses to operate its business, while its liabilities and equity are two sources that support these assets. But prior to this, identification of transaction is very important to incorporate the same in financial statements.
The first step is to recognize whether the transaction is in relation to revenue or expense or is capital in nature. Only transactions of capital nature are reflected in Balance Sheet. Say for Example, any advances received from third party will be shown in the assets side of the Balance Sheet and not as an income in the income statement, as it is capital receipt in nature
Thus, it is important to place it under proper sub – head. The heads of Balance Sheet are sub divided, to facilitate better division of items included within them. To continue with the above example, since it is concluded to incorporate it on the assets side, the same will be reflected under the sub head “Loans & Advances”
Sub-heads of Assets:
Fixed Assets: These include tangible assets like buildings, machinery, furniture, or intangible assets like Patents, Trademarks, and Goodwill. It shows all the assets that are present with the business to provide with long-term benefits, and are not expected to liquefy before a year.
Investments: Investments currently present in external entities made by the business.
Current Assets, Loans and Advances & Miscellaneous Expenditure : Those assets which can be converted into cash within one year like Bills Receivables, Cash in hand, Bank Balance, Advances made to Creditors, dues from Debtors, Stock-in-trade, etc. It helps in determining the liquidity of the concern and its ability to pay back short term liabilities.
Miscellaneous Expenditure includes: Deferred Revenue Expenses, like advertisement expenditure, underwriting commission, share issue expenses etc which are written-off proportionately over a period of time. It is important to stress here that startups and small businesses should need to incorporate all the pre-incorporation and other startup expenses under this head.
Sub-Heads of liabilities:
Share Capital: This head is popularly known as owner’s source of funds as it highlights the basis of funding of the business.
Reserves and Surplus: It includes the retained and plough back earnings of the business that it earns from internal operations. High Reserves and Surplus indicate internal efficiency of business
Loans and Current Liabilities: These include classification of loans into Secured and Unsecured Loans. For example, Bank Loans, Debentures, etc. These are long-term in nature (May last for at least more than a year)
Current Liabilities are similar to Current Assets, in the sense, it includes those liabilities which are due to be cleared within a year’s time, like Bank overdrafts, Bills Payables, Advances from debtors and dues to Creditors.
Net of Current Assets and Current liabilities (also known as Net Working Capital) is considered as a strong financial tool for determining operational efficiency and the strength of the business after clearing all short term dues.
Balance Sheet enables determining key financial ratios and is also utilized for analyzing financial and structural trends. For example, is the receivables cycle lengthening? Is some debt uncollectible? Are Net Profits being retained in the business for future growth or being withdrawn by the owners? What does the operating cycle indicates? Are the debts of the concern trending up or down?
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