A balance sheet is a snapshot in time of what a company owns (assets), what it owes (liabilities) and the shareholders' interest in the company (stockholders' equity). The balance sheet is used internally to help manage the company and externally to report the company's financial condition. The advantages of the balance sheet involve the important information it conveys; however, the use of outdated values for certain assets is a major disadvantage.
Advantage: Keeping Things in Balance
The balance sheet equation shows that a company's assets equal its liabilities plus its stockholders' equity. Since this equation must always hold, any deviation from it indicates a failure of the company's accounting systems. The highly structured format of the balance sheet breaks the three major components into a series of accounts with dollar values as of a given date. As such, it is a compact, easily understood source of current information, and it shows trends when compared to previous balance sheets.
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Advantage: Calculating and Analyzing Ratios
One of the benefits of a balance sheet is that managers, investors, lenders and regulators take the measure of a company by calculating financial ratios using information from the balance sheet, often in conjunction with other reports such as the income statement. For example, balance sheet data is used to examine liquidity, which is the ability of the company to pay its current bills, by dividing current assets by current liabilities (the current ratio). There are dozens of balance sheet ratios that help show how a company compares to its competitors and can help detect important financial trends.
Advantage: Obtaining Credit and Capital
The importance of a balance sheet is also evident should a business need to obtain lines of credit or loans. Before a lending institution will lend money or extend lines of credit to a new or established business, the lender will likely require a balance sheet to help assess a business' creditworthiness and financial state. If your balance sheet is accurate and up-to-date, it will provide the lender with a picture of the business' ability to repay its debt. Without a balance sheet, the lender generally will require other records or deny the loan entirely.
Disadvantage: Misstated Long-Term Assets
Long-term assets are expected to last more than one year and include items like property, plant and equipment. The balance sheet records the value of long-term assets at the price paid for them, known as the historical or book value. One of the limitations of a balance sheet is that it ignores the current value of these assets.
Depreciation reduces the value of long-term assets according to an arbitrary schedule created for tax purposes but does not necessarily reflect real wear and tear. Furthermore, the balance sheet ignores any gain in value or the money it would take to replace an asset at current prices. Book value can substantially understate long-term assets, distorting the wealth of the company.
Disadvantage: Missing Assets
Only assets acquired by transactions are reported on the balance sheet. Therefore, it omits some very valuable assets that are not transaction-oriented and can't be expressed in monetary terms. For example, a company might have a highly valuable group of technical experts that would be hard to replace but are not reported on the balance sheet. In addition, assets developed internally, such as an online internet sales channel, can have tremendous value that the balance sheet ignores.