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Balance Sheets as Financial Statements

Financial statements are a key source of information that are used to make important financial decisions. Of course, one of the most convenient means of summarizing a firm’s assets and liabilities is the use of a balance sheet. Balance sheets are very convenient when making an annual financial report since they can be used to quickly view a firm’s equity at any given point throughout the year. The left side usually includes either the fixed or current assets. Fixed assets have long lives and are either tangible like computers or intangible like trademarks or patents. Current assets last for less than one year and then converted to cash. An example is the firm’s inventory or the money owed by customers.

The right side of the balance sheet contains the firm’s liabilities. Liabilities can either be current or long-term. Current liabilities are like current assets, they must be paid within one year. Long-term liabilities include such things as loans. The difference between the total value of the assets and the liabilities is referred to as the common equity. In an annual financial report, the common equity is the residual value that shareholders would claim if the firm sold all its assets and paid off its debts.

Another feature of a firm’s assets is liquidity. This is the speed and ease with which a firm can convert its assets to cash. Liquidity has two dimensions: the ease of conversion against the loss of value. An asset is considered highly liquid if it can be sold quickly without a loss of value. An asset that would require a substantial price reduction to be converted to cash quickly is considered illiquid. Gold is a good example of a liquid asset. In an annual financial report, assets should be listed in order of their decreasing liquidity. This means that the most liquid asset is listed first. Current assets are considered relatively liquid while inventory, for many businesses, is considered the least liquid. Generally, the more liquid a business is, the less likely it will experience financial difficulties.

Balance sheet statements are potentially useful. Potential creditors can use them to examine a firm’s degree of financial leverage and liquidity. Managers can be able to keep track of inventory and cash on hand. However, it has to be remembered that the real worth of a firm is not reflected on its annual financial report or balance sheets. The most valuable assets, which include, a firm’s good reputation, management and talented employees cannot be put on the balance sheet.

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