In this article we will explore the differences between the Profit and Loss Statement and the Balance Sheet.
Small business owners have to manage many things from dealing with customers to managing employees. Amidst all this, they also have to keep an eye on their business activities and profitability.
In Finance and Accounting there are three financial statements that are the core component of all financial matters in any company, big or small.
These three financial statements are: The Profit and Loss statement, Balance Sheet and the Cash Flow statement. In this article we will focus on the P&L and the Balance sheet, and in coming weeks we will talk more about the cash flow statement later we will do a deep dive in to how to link all of the three statements together and what this tells us about the financial health of a company or firm.
As a summary the overall and fundamental objective of these financial statements is to help business owners know which areas are performing well and which areas need improvement. Is your firm lean on overhead and costs but is taking too long to collect money for services rendered? Most likely you will find out how to solve these issues by doing a quick analysis of your accounts payable and receivables, both of which can be found on the Balance sheet.
It is important to note that in accounting for service-based business both financial statements serve different purposes. Let’s look at the difference between these two financial statements:
Profit and Loss Statement
The Profit and Loss Statement, often called as the income statement or P&L for short, indicates the profitability of your business over a given period in time. In short, it shows you how much revenue you have earned and how much expenses you have incurred in a fiscal year or a fiscal quarter.
Revenue refers to money that is received from the sale of goods and services or interest received from a loan while expenses include taxes, insurance, utilities, rent payments, etc.
The formula to calculate the profit is really simple: Revenues minus Expenses.
If it’s a positive figure, it is your net income. However, if it's a negative number, it is your net loss.
The Profit and Loss statement helps to know how well your business is performing. If it is not performing well, business owners should make necessary changes; otherwise, the company will probably run in to financial trouble well before you even notice.
It is important to note that a positive profit in your P&L statement does not actually mean you have a positive cash flow, or money coming in to cover all of your expenses, many times companies will post a profit but in reality they are cash poor and have liquidity or solvency issues (we will talk more about this on our next article).
The Balance Sheet is composed of the business’ assets, liabilities and shareholders’ equity. It is also known as a statement of financial position that shows the assets and liabilities of your business.
But what are Assets? Easy, Assets are things that your company owns like accounts receivable (sales made but not necessarily money received), Inventory, Cash, Equipment such as Property Plant or Equipment (PPE), Vehicles, Furniture, you get the idea it is things you or your company owns and help you make money. They’re categorized on the balance sheet and hold a measurable value.
What about Liabilities? Liabilities are money that a company owes, some examples of liabilities are Loans, Mortgages, Accounts Payable, Differed Revenues, Accrued Expenses, etc.
All the company’s debts are liabilities. Liabilities are also classified into short-term and long-term on the balance sheet.
The Balance Sheet also includes owner’s equity (shareholder’s equity) which is the difference between assets minus liabilities. It is the money left that you can take ownership of.
Inside of shareholder’s equity is an account called retained earnings this one is important because if shows us the amount of profit the company has reinvested or used to pay down debt, instead of being distributed to shareholders as dividends.
Overall the Balance Sheet shows a bigger picture by telling your business worth at a specific
point in time and not spread over the course of a time period like the P&L statement. It also tells us what we own (Assets) and what we owe (Liabilities).
Profit and Loss vs Balance Sheet
The Balance Sheet statement talks about your financial status, whereas the Profit and Loss statement shows a comparison of your spending and your income. However, both statements can be used together to analyze your company’s operational efficiency.
You can determine your company’s inventory turnover and accounts receivable turnover. Inventory turnover is evaluated by dividing annual cost of goods sold by the inventory balance. For example, if the annual cost of goods sold is $6,00,000 per year and $2,00,000 per year is the inventory balance, then your inventory turns over three times per year.
Accounts receivable turnover is evaluated by dividing total sales from the profit and loss statement by the accounts receivable balance. For example, if total sales are $1.5 million and balance in accounts receivable is $100,000, then your accounts receivable turnover is 15 times per year.
Also, both these statements can help to determine your company’s ability to pay its debts. It is done by dividing the annual cash flow by the total amount of principal payments on debt. A generally accepted ratio is $3 in cash flow for each $1 of principal payment.
Profit and Loss and Balance Sheet statements play an important role in your bookkeeping and accounting system as it benefits business owners in multiple areas. However, as noted at the beginning of the article these are not the only statements to look at when analyzing a business financial performance, this is why later we will discuss more about the Cash Flow statement and what it tells us about a company and down the road we will also learn how to tie all of the three financial statements together and what to do with that information.
A side note from the editor: Business owners should regularly update all financial documents for transparency, reporting and analytics and obviously tax reasons. If you have any questions regarding financial statements and need a hand understanding them better, please do not hesitate to contact us, the Irazu Advisors continuing education team will gladly help you out better understanding your company’s finances.