It is often impossible to fully understand a business’s financial health through financial reports. In other words, using only a balance sheet or proof of income will only give you a partial picture of the company’s health.
On the other hand, combining these two statements can give you a better perspective and understanding. But more importantly, you also need to be able to tell them apart. This article aims to achieve that; to help you understand the relationship and differences between a balance and an income statement (balance sheet vs. income statement).
This article covers:
What is the balance sheet (B/S)?
A balance sheet provides a detailed view of your company’s assets and liabilities. Creditors and investors often use it to analyze your company’s financial health. Think of your balance sheet as a direct picture or reflection of your company. It describes the financial position of your organization on a given date.
Basically, your company’s balance sheet covers three of the five account types; assets, liabilities and equity. The general accounting formula comes from the balance sheet format:
Liabilities + equity equals assets
Office Clerk: Includes cash, accounts receivable, inventory, machinery, and real estate owned by your company. Intangible assets, or items of value that cannot be touched or felt, also fall into this category.
Current assets and long-term assets are two types of assets. Current assets, such as commodities, may turn into cash quickly, while long-term assets, such as property, are things you intend to hold for a long time.
On the other hand, your company’s liabilities, such as accounts payable and notes payable, are called liabilities. Like assets, liabilities can be either current or long-term. Current liabilities must be paid within the next year, while long-term liabilities must be paid over a longer period.
Equity is the amount you and your investors invest in the company. You have constructed a proper balance sheet when the sum of equity and liabilities equals or balances your assets.
|Total Liabilities & Equity
In this example, the table showcases the balance sheet of a company. The assets section includes current assets (cash, accounts receivable, inventory) and long-term assets (property, machinery). The liabilities section includes current (accounts payable, notes payable) and long-term liabilities (bank loan, mortgage). The equity section represents the owner’s investment and retained earnings. The total assets, liabilities, and equity are balanced, with the sum of liabilities and equity equaling the total assets.
The balance sheet proves that Assets = Liabilities + Equity, a basic accounting equation.
While a balance sheet is a useful analytical tool for creditors and investors, it doesn’t give you the full picture of a company’s value. Here are some of its limitations;
- Individual assets on the balance sheet rarely appreciate in value
Assets must be recorded at purchase price, and most long-lived assets must be depreciated. Assets have not increased from historical or book value to market value.
- A balance sheet represents your company’s assets and liabilities as of a specific date, but it can change daily, just like your personal bank account.
Consider what would happen if your balance sheet was ready shortly after you paid off a large amount of debt and before you delivered large customer orders. You have a temporary cash crunch but can only sometimes explain it on the balance sheet.
Your business income does not show up on your balance sheet
Since not all organizations grow by purchasing new assets, it is harder to spot growth on the balance sheet. For example, rising incomes are one way the services sector shows growth.
What is the income statement (P/L)?
An income statement, also known as an income statement, shows your company’s earnings over a period of time. Income and expense accounts are two types of accounts on the income statement.
Typically, income statements come in various types, but they all use a similar formula.
Net Income = Revenue – Expenses.
The classic income statement shows revenue, expenses, and net income in either a single or multi-step format.
The multi-step format of the income statement distinguishes between business operations and other activities, such as investments. This more comprehensive format allows readers to see the proper health of your company without the impact on your assets.
|Cost of Goods Sold
|– Other Expenses
|Total Operating Expenses
|– Investment Income
|– Rental Income
|Total Non-Operating Income
In this example, the revenue from sales is $250,000, and the cost of goods sold is $120,000, resulting in a gross profit of $130,000. The operating expenses include various categories such as marketing, salaries, rent, utilities, and other expenses, totaling $100,000. The operating income is calculated by subtracting the total operating expenses from the gross profit, resulting in $30,000. The non-operating income includes investment income and rental income, totaling $8,000. Finally, the net income is the sum of the operating and non-operating income, amounting to $38,000.
Unlike the one-step income statement, the multi-step income statement estimates gross profit.
When you look at gross profit, which is the difference between sales and cost of sales, you’re looking at a multi-step income statement.
Operating income is also the most valuable line on a multi-step income statement. It’s easy to watch how your business is doing outside of investments, as the format clearly shows operating expenses.
At the same time, the income statement alone cannot fully reflect the company’s health. There is a net operating loss in the above scenario, but there is no opportunity to explain why.
The income statement makes no mention of the company’s debt. Although earnings may appear strong, you should consider the company’s health if it is about to pay down debt or is low on cash.
What is the relationship b/w the balance sheet and the income statement?
Even though they are different, these financial reports are related to one another whose components cannot be separated.
Equity, which is part of the balance sheet, is increased by the part of the profit for the year that is not paid to the shareholders. Similarly, equity will be reduced if the company ends up with a negative result for the financial year.
The income statement, therefore, provides an overview of income and expenses in the financial year. In contrast, the balance sheet provides an overview of the company’s total value throughout the years at a given time (the year-end date).
Let’s systematically understand the relationship between the balance sheet and the income statement!
Let’s systematically understand the balance sheet and the income statement!
It is very important to systematically understand the relationship between the balance sheet and the income statement. Now, let’s consider one example based on the above points.
Suppose you establish a company with a capital of $1,000. At this time, the capital is $1,000, so the capital is $1,000. The money becomes the company’s assets as cash. Therefore, the asset cash is $1,000. The income statement isn’t working because the company hasn’t bought or sold (transaction) yet. In other words, it looks like this.
- Balance sheet
|Amount of sales
The following month, the company receives a $10000 loan from the bank. Borrowing is a liability, so the debt will increase by $10000, and the funds raised will be $10000 as assets of the company, all of which will be cash. And since the company isn’t buying or selling, the income statement movement remains zero. In other words, it is recorded like this.
|Liability $10000 Capital $10000
After that, the company sells the item for $800. If you sell it, you will get $800 in cash. In other words, the product will run out of $500 and will be cash instead. You also sold the one for $500 for $800, so the profit is $300. This profit will be capitalized as cash.
On the other hand, on the credit side, the profit of $300 is not the money borrowed or paid-in capital, so it is recorded in the item “Retained earnings”. If it is an expense rather than an income, it will be negative because the capital portion will decrease. And since there was a buying and selling movement in the income statement, we will reflect on the balance sheet’s movement. In other words, it looks like this.
|Liability $1,000 Capital $1,000 Profit $300
|Amount of sales
In this way, past profits and losses on the balance sheet are reflected in the income statement’s trading results.
What should we read first: the balance sheet or the income statement?
In general, we start by reading the income statement to assess the company’s economic performance over the last financial year.
After reading the income statement, we begin to read the balance sheet to assess the company’s financial situation at the closing date of the financial year.
The result links the balance sheet and the income statement for the year. The income and expenses appearing in the income statement are balanced at the end of the financial year. The resulting difference corresponds to the net income, which is then included in the balance sheet’s liabilities in equity.
Important information found in an income statement
The income statement provides in particular information on:
- The formation of the net profit for the past financial year, by breaking it down into several results (operating profit, financial profit, exceptional profit);
- The company’s turnover for the past financial year;
- The volume of purchases made by the company over the past financial year and the variation in its stocks;
- The company bears external costs;
- The company’s payroll and employer contributions;
- The cost of the company’s financing policy, in terms of financial charges;
- Expenses relating to unusual events, at the level of exceptional charges.
Important information found in a balance sheet
In particular, the report provides information on:
- The company’s equity. It includes the contributions in share capital and issue premiums, the reserves accumulated thanks to the performance of previous years, and the result for the closed year (which also appears at the bottom of the income statement);
- The composition of the company’s fixed assets and its (value of net fixed assets/value of gross fixed assets). The importance of this part of the balance sheet depends on the activity of the company. For production companies, the condition of fixed assets is essential. For service companies, it is often less so;
- The total amount of supplier debts, i.e., supplier invoices not yet paid at the year-end date. These must be settled after the end of the financial year;
- The total amount of tax and social debts, which corresponds to the sums remaining to be paid to the tax administration (VAT, corporation tax, etc.) and social organizations at the end of the financial year;
- The total amount of trade receivables, i.e., invoices sent to customers that have not yet been paid on the year-end date. These will be paid to you after the end of the financial year;
- The value of the company’s inventories at the year-end;
- The cash flow statement and any investments of the company at the end of the financial year.
What is the difference b/w the income statement and the balance sheet?
The income statement and the balance sheet are completely linked to double-entry bookkeeping. Double-entry bookkeeping requires two separate entries for every transaction recorded in a company. The income statement has one of these entries, and the balance sheet has another.
Also, every time a sale or expense is recorded, the assets and liabilities on the balance sheet are modified, affecting the income statement. In other words, when a company makes a sale, its assets increase, and its liabilities decrease. On the other hand, when a company reports an expense, it reduces its assets and increases its liabilities. Therefore, income statements and balance sheets are inseparable.
A balance sheet of a company is divided into assets and capital and thus shows all the company’s stocks. In contrast, an income statement shows success by comparing expenses and income.
The balance sheet shows the financial security and stability of a company with the help of various key figures, such as the equity ratio. The income statement shows previous costs and sales, as well as profits received.
When it comes to calculating different values, you need a set of calculations in your income statement. You only need to collect all revenue and all expenses and subtract the total cost from the total income for profit or business loss.
The calculation of the owner’s equity on the balance sheet requires several calculations. For example, an entity must retain its assets from its owner in order to retain its ownership, and the assets must always be equal to the shareholder’s capital and liabilities. (https://fii-institute.org/) This ensures that the balance sheet is appropriately executed.
The primary purpose of preparing the income statement is to determine the company’s profit or loss from its business activities. Income and expenditure are divided into different categories, making it easier to determine the source of profit and loss. On the other side, the balance sheet is also called the statement of financial position, and its function is to provide an overview of the company’s position in its financial position.
As the term “balance sheet date” suggests, this is a snapshot of a single point in time in which all financial resources are shown. The difference here: in the income statement, the company is analyzed over a certain period, for example, a year or quarter.
However, the annual surpluses must match the income statement and the balance sheet at the end. Both are essential parameters in accounting – for you and your further planning, as well as for the third parties involved. Despite a difference in the list, they provide information about profitability and success and are therefore essential for proper bookkeeping.
Parts that are important and you need to know in the balance sheet.
You need to know that in making a balance sheet, the amount in assets always equals the number of liabilities (liabilities and capital). The balance of the two is described as an accounting equation, which is an equation that shows the amount of all listed assets as coming from the creditor, the owner. On the other hand, the amount contributed by creditors and owners must be the same as the number of assets in the company
- Assets are resources possessed by a company, which is usually calculated in units of money. The type of financial resources in the company is called the assets of the company. Of course, these assets consist of various kinds such as land, buildings, machinery, accounts receivable, prepayments (advances), etc. Usually, these assets are listed on the balance sheet, in a definite order, starting from current assets (cash, accounts receivable, inventories). After that, other assets such as assets that are permanent (land, buildings, machinery, and so on) will be followed. (https://teamtapper.com)
- Liability, namely debt that is obligatory or must be paid by a company, with money or with services at a certain time. It can be said that liabilities are debts of creditors to a company, usually, first, a short-term obligation, such as trade payable, notes payable, is included. Then under short-term liabilities, there are long-term liabilities such as mortgage debt.
- Then for this capital, you also need to enter it in the balance sheet. And this part of capital is listed in the section below the obligations; this capital is a right that is owned by a company.
Important parts that you need to know in the Income Statement
A number of the things you should know in the profit or loss statement, namely. In this profit or loss statement, the title consists of a company’s name and is given the name of the report (income statement). This income or loss statement also includes the reporting period and the contents of the income statement. Therein consists of three main components, such as income, costs, profit, which means:
- Income is the flow of money or other assets that the company receives from one of the consumers. This results from the sale of company goods, not only that the company can also provide services to its consumers.
- Cost is one of the costs of goods or products and can also service. What is sold by a company by its consumers to earn or generate income.
- Profit or loss, namely the difference between more or less costs, from the operational costs or initial capital.
Detailed layout according to the Accounting Principles
- sales revenue
- other operating income
- cost of goods
- change in inventory of goods under construction and finished goods
- labor cost
- impairment of plant, property and equipment and intangible assets
- other operating expense
- operating profit
- income from investment in subsidiaries
- income from investment in another enterprise in the same group
- income from investment in associated companies
- interest income from companies in the same group
- other interest income
- another financial income
- change in value of market-based financial current assets
- write-down of other financial current assets
- write-down of financial fixed assets
- interest expense to companies in the same group
- Other interest expenses
- Other financial cost
- ordinary profit before tax expense
- Taxes on ordinary result
- ordinary result
- extraordinary income
- extraordinary cost
- tax expense on extraordinary profit
- fixed assets
- intangible assets
- fixed assets
- Financial fixed assets
- current assets
- Bank deposits, cash, etc
- equity and debt
- paid-in capital
- earned equity
- provision for liabilities
- Other long-term debt
- short-term debt
Why are balance sheets and income statements both important?
We have clarified the difference between the balance sheet and the income statement. It now remains to understand why it is necessary to include both in the financial statements.
Every action from the company’s management point of view must be reflected and therefore represented within the financial statements, translating it into numerical language.
Only by keeping track of every single event, even the smallest, that produces effects for monetary purposes, is it possible to achieve responsible management of resources and the entire company.
Balance sheets and income statements are essential for establishing a transparent financial situation, which will then determine the tax burden.
In addition to providing their data to the tax authorities, the balance sheet and income statement, therefore, the balance sheet is handy for keeping the situation under control.
Often entrepreneurs limit themselves, due to lack of time or lack of information, to completely delegating everything to the accountant.
However, this does not give him the possibility to control and intervene in real-time.
Structure of the income statement
- Total sales: Represents the value of goods delivered to customers, sold in cash or on credit.
- Profitability on sales: The value of the merchandise that customers return because they did not like it at all.
- Sales discounts: The amount for which discounts were granted on the sale prices of the merchandise.
- Purchases: It is the value of the goods purchased.
- Purchase expenses: These are the expenses that must be made to acquire the merchandise, for example freight, transport, insurance, loading, unloading, etc.
- Purchase returns: This is the value of the goods returned to the suppliers because we did not like them.
- Discounts on purchases: The amount for which we are granted discounts on the purchase prices of the merchandise.
- Initial inventory: The value of the goods in stock.
- Inventory closing: The value of the goods at the end of the year.
- Selling or direct costs: These are the expenses directly related to the sales process, for example, salaries of promoters’ staff, sellers, advertising and advertising, shipping costs, rentals and maintenance of buildings or commercial premises, depreciation and expenses maintenance of distribution equipment, etc.
- Administrative or indirect costs: These are the expenses necessary for the maintenance of the administrative area of the company, for example, salaries of administrative staff, rent, and maintenance of offices, stationery, telephone, electrical energy of the offices, depreciation expenses, and maintenance of equipment IT, office furniture and equipment, etc.
- Financial expenses and products: The expenses and income derived from the gains or losses in the foreign currency exchange, the interests paid or paid by the entity, the bank commissions, etc.
- Other expenses and other products: These are the expenses or income derived from unusual operations for the entity, for example, gains or losses from the sale of fixed assets, income collected, purchase and sale of shares, etc.
Structure of the balance sheet
The balance sheet’s basic structure is theoretically based on the accounting balance formula of “assets = liabilities + owner’s equity”. The left side of the sheet is the company’s assets; that is, the company’s various economic assets in its commodity operations. Resources. The right side of the sheet is the capital invested by the company’s investors (creditors, equity holders) and the company’s retained profits.
(1) The head of the table. The head of the table is the basic mark of the report, which lists the report’s name, the preparation unit, the number of the report, the date of preparation, and the amount unit. Since the balance sheet is a statement that reflects the static funds at the end of the period, the date of the report should be the date of the last day of the end of the reporting period.
(2) The basic part. The basic part is the statement’s main body, and the balance sheet is divided into the left and right sides.
Assets listed on the left:
1) Current assets. Including monetary funds, transactional financial assets, notes receivable, accounts receivable, provision for bad debts, advance payments, other receivables, inventory, etc.;
2) Non-current assets. Including available-for-sale financial assets, held-to-maturity investments, fixed assets, intangible assets, etc.
The rights are listed on the right. Specifically include debt items:
1) Current liabilities. Including short-term loans, bills payable, accounts payable, advance receipts, other payables, employee compensation payable, taxes payable, etc.
2) Long-term liabilities. Including long-term loans, bonds payable, long-term payables, etc. Owner’s equity items include paid-in capital, capital reserves, surplus reserves, undistributed profits, and other items.
What is the best financial statement for a small business?
The successful operation of your small business relies on four crucial financial statements
A balance sheet
In preparing financial reports, usually, the first report to be made is a balance sheet. By writing a balance sheet, you can find out how much your business assets are. People usually use a simple formula: Price = Debt + Equity.
The easiest and most common report you will need is the income statement. With this report, you can find out your business’s revenue or profit figures.
Cash flow statement
After creating an income statement, you can continue by creating a cash flow statement. This report is simple but practical because you can see how much money is coming in and going out in your business activities.
Capital change report
Furthermore, although it’s not mandatory, you can make a capital change report if necessary. You must complete this report if you inject capital into business operations. Usually, capital injection is required when you want to grow your business or if your income needs to be more significant to run the business.
Why does every business need to make financial reports?
Every business or company uses financial reports to see the company’s condition during a specific period. The source of the data is processed to become a clear and detailed financial report. Every recorded transaction data will prove the validity of business transactions for a certain period.
Every business needs to understand the difference and relationship between a balance sheet and income statement. Both of these financial statements are essential for a company’s success. The balance sheet shows a company’s assets, liabilities, and equity, while the income statement displays its overall profit or loss. Having a good grasp of these documents can assist businesses in making informed financial decisions.