Uses and Limitations of the Balance Sheet

Introduction

The balance sheet can provide very useful information to users of financial statements. It, however, has several limitations to its use.

Uses of the Balance Sheet

The balance sheet gives insight into a company’s financial condition at a particular point in time. It reflects the resources that are controlled by the company as well as how these resources were financed.

The balance sheet can assist analysts in assessing a company’s ability to:

  • pay for its near-term operating needs (liquidity position);
  • meet future debt obligations; and
  • make distributions to shareholders.

Limitations of the Balance Sheet

  • Items on the balance sheet are not all measured in the same manner; some assets and liabilities are measured at historical cost, while others are measured based on their current market value. The measurement method used can significantly impact the amounts that are reported.
  • Items measured at current value reflect the value that was ‘current’ at the end of the reporting period. These values can, however, change significantly after the balance sheet is prepared.
  • The balance sheet does not incorporate important aspects of a company’s ability to generate future cash flows such as its reputation and management skills.

Question 1

Which of the following statements is incorrect?

A. Items on the balance sheet are not measured in the same manner.

B. The balance sheet cannot assist in assessing a company’s ability to satisfy future debt obligations.

C. An analyst can use the balance sheet to assess a company’s ability to pay for its short-term obligations.

Solution

The correct answer is B.

This statement incorrectly states that the balance sheet cannot assist in assessing a company’s ability to satisfy future debt obligations. This is not correct; the balance sheet can assist in assessing a company’s ability to satisfy its future debt obligations as well as pay for its short-term obligations (Choice C). Choice A correctly states that items on the balance sheet are not measured in the same manner; some are measured at historical cost, while others are measured based on their current value.

Question 2

One of the main limitations of using the balance sheet in financial analysis is:

A. The difference in measurement bases among assets.

B. The difference of balance sheets preparation methods among companies.

C. None of the above.

Solution

The correct answer is A.

The difference in measurement bases among items is one of the main limitations of the usage of the balance sheet in financial analysis, as some items are measured at historical cost, and some others are measured according to their current value.

 

Reading 24 LOS 24b:

Describe uses and limitations of the balance sheet in financial analysis

 

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