Balance sheets and income statements are important tools to help you understand the finances and prospects of your business, but the two differ in key ways. Knowing when to use each is helpful in creating visibility into the financial health of your business.
If you don’t have a background in accounting or finance, these terms may seem daunting at first, but reading and analyzing financial statements remains a requisite skill for business owners and executives. This guide will give you a comprehensive overview of both financial statements.
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A balance sheet shows the financial position of the business at a specific point in time. The balance sheet is the cornerstone of a company’s financial statements, providing a snapshot of its financial position at a certain point in time.
It includes what the company owns (its assets), what it owes (its liabilities) and owner’s equity, which includes money initially invested in the company, along with any retained earnings attributable to the owners or shareholders.
This statement is divided into two columns, based on the following equation:
Liabilities + Shareholder’s equity = Assets
This equation forms the foundation of a balance sheet, with assets in one column, equal to the liabilities and the owner’s equity in the other.
The balance sheet reflects the company’s performance since its inception, encompassing every single transaction, the amounts raised, the debts accumulated, the assets acquired and their present valuations, all presented in a single statement.
This provides insight into the operations, finances and future prospects of the company using financial ratios, such as debt-to-equity, which reflects the company’s ability to pay its debts using equity or the current ratio, which divides current assets by current liabilities to determine the company’s ability to meet its obligations over the next 12 months.
The acid-test ratio adds further clarity to the current ratio by only considering easy-to-liquidate assets, providing a more accurate picture of a company’s ability to meet obligations.
The balance sheet comprises assets, liabilities and owner’s equity toward the end of the accounting period.
In simple terms, owner’s or shareholder’s equity is equal to the total assets attributable to owners or shareholders in the event of the company’s liquidation, after paying all debts or liabilities.
This segment of the balance sheet includes return of equity (ROE), calculated by dividing net income by shareholder’s equity. ROE measures management’s effectiveness in employing and driving returns based on equity.
Shareholder’s equity also includes retained earnings ― the portion of the net income that hasn’t been distributed to shareholders as dividends ― to be used for funding further growth and expansion of the business.
Management will generally aim to maximize return on equity and return funds to shareholders in the form of dividends or share repurchases when it is unable to generate sufficient returns with these retained earnings.
An income statement assesses the profit or loss of a business over a period of time. Also known as the profit and loss (P&L) statement, the income statement summarizes the financial performance of a business during a specific period, reporting revenues, cost of goods sold, overheads and the net profit attributable to shareholders.
The P&L statement is one of three key financial statements a business releases, either quarterly, annually or both if it’s a public company. It keeps track of profitability, income sources, expenses and budgets, allowing the company to take action against variances from projections. Investors and lenders pay attention to the P&L statement, especially when comparing different periods to determine the long-term trajectory of the company.
To a skilled analyst, the data presented in a profit and loss statement can provide deep insights with the use of ratios. These include the gross and operating margin ratio, which highlights the company’s profitability in relation to the sales and expenses incurred, the price-earning and return-of-equity ratios to assess efficiency in capital allocation and the times-interest-earned (TIE) ratio to measure the margin of safety a company has to meet its debt payments.
The income statement focuses on four key items: sales revenues, expenses, gains and losses. It does not concern itself with cash or noncash sales or anything regarding cash flow:
Here is a quick reference for the key differences between the balance sheet and income statement, summarizing what we’ve discussed above.
The balance sheet summarizes the financial position of a company at a specific point in time.
The income statement provides an overview of the financial performance of the company over a given period.
It includes assets, liabilities and shareholder’s equity, further categorized to provide accurate information.
It includes revenues, expenses and gains and losses realized from the sale or disposal of assets.
It helps assess financial health using ratios, such as current ratio, debt-to-equity ratio and return on shareholder’s equity.
Ratios, such as gross margins, operating margins, price-to-earnings and interest coverage, paint a picture of financial performance.
Investors and lenders use it to determine creditworthiness and availability of assets for collateral.
Management, investors, shareholders and others use it to assess the performance and future prospects of a business.
The balance sheet and income statements complement one another in painting a clear picture of a company’s financial position and prospects, so they have similarities.
Along with the cash flow statement, they comprise the core of financial reporting. Errors or omissions in either of them create inaccurate results across all of them.
The income statement and balance sheet follow the same accounting cycle, with the balance sheet created right after the income statement.
If the company reports profits worth $10,000 during a period and there are no drawings or dividends, that amount is added to the shareholder’s equity in the balance sheet.
These and other similarities keep them reliant on each other and make them both essential in providing a clear and complete picture of accounts.
Given the importance of income statements and balance sheets in financial reporting, accounting software is invaluable. It can reduce mistakes or omissions that would result in flawed or inaccurate financial statements.
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It’s difficult to guide a business to success and growth if you don’t know your financial circumstances. Income statements and balance sheets are two essential tools in the entrepreneurs arsenal for keeping tabs on their revenue, expenses and cash flow. Fortunately, you don’t need to be a chief financial officer to produce these documents. With the help of the best accounting software on the market, you can generate these reports automatically and have them sent to key stakeholders in your company on a recurring basis.
Tejas Vemparala also contributed to this article.