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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What is a balance sheet?
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.
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.
Assets
- 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 noncurrent assets.
Liabilities
- Debt: Debts are any sums of money owed to lenders, banks or suppliers. They can be classified as either current liabilities or noncurrent 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: Employee 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 noncurrent 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 circ*mstances 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?
An income statement assesses the profit or loss of a business over a period of time. Also known as the , 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 noncash 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 divided further into operating revenue or revenue generated from the core activities of a business and nonoperating revenue, which includes noncore sources such as interest income and rental earnings.
- Realized gains and losses: Also referred to as “other income,” these are one-time, nonrecurring gains that arise from the sale or disposal of assets. These may include sales of real estate, minority holdings in other firms or a subsidiary company. Meanwhile, 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, 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.
Are you in the market for accounting software? Consider our picks for best accounting software. These include our QuickBooks review, which highlights one of the most popular solutions on the market as well as our FreshBooks review, Xero review and Zoho Books review, to name a few of the leading platforms out there.
Know your business’s finances to succeed
It’s difficult to guide a business to success and growth if you don’t know your financial circ*mstances. 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.
