- Balance sheets and income statements are invaluable tools for business owners to measure their company's performance and prospects, but they differ in key ways.
- A balance sheet provides a snapshot of a firm's financial position at a specific point in time, while an income statement – also known as a profit and loss statement – measures performance over a period of time.
- Accounting software helps to manage both of these financial statements.
- This article is for small business owners who want to understand how to use balance sheets and income statements.
Balance sheets and income statements are important tools to help you understand the health and prospects of your business, but the two differ in key ways. This guide will give you a comprehensive overview of both financial statements.
The balance sheet and income statement represent important information regarding the financial performance and health of a business. An income statement assesses the profit or loss of a business over a period of time, whereas a balance sheet shows the financial position of the business at a specific point in time.
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The balance sheet and income statement complement each other in providing a complete picture of a company's financial position and future prospects. Both are crucial for decision-makers, investors and financial institutions.
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.
What is a balance sheet?
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.
Did you know? 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.
What's included in a balance sheet?
The balance sheet comprises assets, liabilities and owner's equity toward the end of the accounting period.
- Cash and cash equivalents: Listed under current assets, this figure represents the value of the cash held by the company toward the end of an accounting period, along with other cash equivalents, which may include marketable securities and short-term deposits.
- Accounts receivable: This is debt owed to a company for goods and services delivered, but not yet paid for. It can be used as collateral for borrowing money and is listed under current assets in the balance sheet.
- Inventory: This refers to finished goods ready for sale, along with raw materials intended for the production of goods or services. Inventory is also classified under current assets.
- Plant, property, intellectual property and more: These are long-term investments that cannot be turned into cash quickly, aren't directly used in the production process, and have a life of more than a year. This type of property might include trademarks, copyright and goodwill. They are depreciated or amortized based on usage or value. On the balance sheet, they are listed under non-current assets.
- Debt: Debts are any sums of money owed to lenders, banks or suppliers. They can be classified as either current liabilities or non-current liabilities, depending on whether they are long-term or short-term debts. Even for long-term debts, upcoming repayments are included under the current portion of long-term debt.
- Accounts payable: This is the company's outstanding payments owed to suppliers or vendors for goods and services delivered. Given the short-term nature of these obligations, they are classified under current liabilities, often payable within 90 days.
- Underfunded pension plan: Company-sponsored retirement plans with more liabilities than assets are considered underfunded plans, unable to meet their current or future obligations. They are often classified as a non-current liability, and the company is obligated to pay and fill the gaps as and when the need arises.
- Deferred tax liability: This represents taxes that are accrued, but not yet paid. Deferred tax liability often arises from the gap between when the tax is owed and when payment is due, in circumstances of installment sales, or to make up for the accrual/cash timing difference.
Owner's or shareholder's equity
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.
FYI: 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.
What is an income statement?
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.
What's included in an income statement?
The income statement focuses on four key items: sales revenues, expenses, gains and losses. It does not concern itself with cash or non-cash sales, or anything regarding cash flow.
- Revenue: This includes money generated from normal business operations. It is the top line of the company, and represents the total income generated during a specific period. It is further divided into operating revenue, or revenue generated from the core activities of a business, and non-operating revenue, which includes non-core sources such as interest income and rental earnings.
- Realized gains and losses: Also referred to as "other income," these are one-time, non-recurring gains that arise from the sale or disposal of assets. These may include sales of real estate, minority holdings in other firms, or even a subsidiary company. On the other hand, a loss-making sale or disposal of assets is listed under "other expenses," and is often a result of assets selling for prices lower than their valuations on the balance sheet during the specified period in question.
- Expenses: This includes all the costs arising out of the normal course of business, such as the cost of goods sold (COGS), which is the direct cost of materials and labor incurred during the production of goods and services. Expenses also include general administrative costs, which aren't directly linked to the production process, but are essential for the organization, and depreciation or amortization of assets based on usage or fixed schedules.
- Net income/loss: The income statement culminates in the net profit or loss during the period, also referred to as the bottom line. A net profit or loss is what remains after adding realized gains and subtracting expenses and realized losses. This is the figure attributable to shareholders.
What are the differences between a balance sheet and income statement?
Here is a quick reference for the key differences between the balance sheet and income statement, summarizing what we've discussed above.
|Balance sheet||Income statement|
|Time||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.|
|Key items||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.|
|Financial analysis||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.|
|Usage||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.|
What are the similarities between an income statement and a balance sheet?
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.
Can accounting software help you manage income statements and balance sheets?
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.
There are many accounting tools and solutions, which you can read about in our review of QuickBooks accounting software or our FreshBooks accounting software review. There are accounting tools that cater to organizations of all types and sizes. Here are some of the best accounting software solutions, with budget pricing and intuitive user interfaces that can make accounting less daunting.