LOS B requires us to:
describe the uses and limitations of the balance sheet in financial analysis.
The main uses of a balance sheet are:
a. To assess the liquidity position of the firm. A balance sheet does help in assessing the ability of the entity to meet its short-term obligations.
b. To assess the solvency of the firm. Solvency reflects the ability of the firm to meet long-term obligations.
There are however certain major limitations to the usefulness of the information provided by the balance sheet. Some of them are:
a. The value of the equity. The value of equity as reflected in the balance sheet is its book value. It is not equal to the market value or the intrinsic value of the equity. The market / intrinsic value is calculated using the estimates of future cash flow, profitability, and growth rates, etc. It is the historical cost as adjusted for the depreciation or the current cost. It does not reflect the fair value of the owner’s wealth.
b. It does not reflect the value of most of the intangibles, such as the brand loyalty amongst the customers, the quality of management, etc.