Forecasting the Balance Sheet

In financial accounting, a balance sheet or statement of financial position summarizes the financial balances of a sole proprietorship, a business partnership, a corporation, or another business organization. Assets, liabilities, and ownership equity are listed on a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition."|

Of the four basic financial statements, the balance sheet is the only statement that applies to a single point in time of a business calendar year.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods, and they acquire buildings and equipment.

In other words, businesses have assets, so they cannot, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words, businesses also have liabilities.

Balance Sheet An example of a classified balance sheet.

Balance Sheet Analysis

Balance sheet analysis (or financial analysis) is the process of understanding the risk and profitability of a firm (business, sub-business, or project) through the analysis of reported financial information, particularly annual and quarterly reports.

Balance sheet analysis consists of 1. reformulating the reported Balance sheet, 2. analyzing and adjusting measurement errors, and 3. financial ratio analysis based on the reformulated and adjusted Balance sheet. The first two steps are often dropped in practice, meaning that financial ratios are calculated based on the reported numbers, perhaps with some adjustments. Financial statement analysis is the foundation for evaluating and pricing credit risk and for doing fundamental company valuation.

Financial ratio analysis should be based on regrouped and adjusted financial statements. Two types of ratio analysis are performed: 3.1) Analysis of risk and 3.2) analysis of profitability:

3.1. Risk analysis typically aims to detect the firm's underlying credit risk. It consists of liquidity and solvency analysis. Liquidity analysis aims to analyze whether the firm has enough liquidity to meet its obligations when they should be paid. A usual technique to analyze illiquidity risk is to focus on ratios such as the current ratio and interest coverage. Cash flow analysis is also useful. Solvency analysis aims to analyze whether the firm is financed to recover from a loss or a period of losses.

3.2. profitability analysis refers to the analysis of return on capital, for example, return on equity, ROE, defined as earnings divided by average equity. Return on equity, ROE, could be decomposed: ROE = RNOA + (RNOA - NFIR) * NFD/E

Purposes of Balance Sheet Analysis

"The objective of financial statements is to provide information about the financial position, performance, and changes in the financial position of an enterprise that is useful to a wide range of users in making economic decisions. " Financial statements should be understandable, relevant, reliable, and comparable. Reported assets, liabilities, equity, income, and expenses are directly related to an organization's financial position.

Financial statements are intended to be understandable by readers who have "reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently. " Financial statements may be used by users for different purposes:

• Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to give management a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.
  
  
• Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions, or for individuals in discussing their compensation, promotion, and rankings.
  
  
• Prospective investors use financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
  
  
• Financial institutions (banks and other lending companies) use them to decide whether to grant a company fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
  
  
• Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
  
  
• Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.
  
  
• The media and the general public are also interested in financial statements for various reasons.