Balance Sheet vs. Income Statement
Accounting plays a vital role in running any business or organization, from small one-man outfits to large corporations. Accounting helps track income and expenditures, assure statutory compliance, and provide owners, management, investors, and government with crucial financial data for strategic business decisions. While this article will focus on balance sheet vs. income statement, the three most important financial statements are:
- The income statement: reflects profit and loss.
- The balance sheet: gives a snapshot of a firm’s financial position at a specific point in
- The cash flow statement: reflects the cash generated and spent during a specific period of time.
The balance sheet and income statement both provide vital information about the health and performance of an enterprise. The two documents supplement each other, providing a complete picture of a company’s financial health and outlook. This information isn’t only important for business owners who base their business decisions on this data; it’s also crucial for investors, banks, and other financial institutions.
Let’s have a more detailed look at these two important accounting documents.
What is a balance sheet?
The balance sheet provides a snapshot of a company’s financial position at a certain point in time. In other words, it illustrates what a company owns and owes on a certain date, such as March 30, 2021. It is also referred to as a statement of net worth or a statement of financial position.
The purpose of the balance sheet is to show the financial status of a business at a specific point in time. The balance sheet is usually prepared on a monthly, quarterly, or yearly basis.
A balance sheet has three sections: assets, liabilities, and shareholder’s equity. The assets column shows everything the business owns at the time, including cash, property, machinery, trademarks, and more. The liabilities column shows everything the company owes creditors, suppliers, tax authorities, employees, and others. The shareholder’s equity column represents everything else.
The balance sheet must adhere to this formula: Liabilities + Shareholder’s equity = Assets.
The value of the asset column must be equal to the sum of the liabilities and the shareholder’s equity, in other words, the two columns must balance.
What does the balance sheet tell us?
The balance sheet reflects the company’s performance by revealing the present value of all transactions, assets acquired, amounts raised, and debts accumulated. The statement of financial position provides insight into the operation and the future prospects of the company. It can be used to determine a company’s ability to pay its debts and reveals whether the company uses debt or equity to finance assets.
What’s included in a balance sheet?
The balance sheet constitutes assets, liabilities, and owner’s equity at the end of an accounting period.
- Cash and cash equivalents are listed under current assets, which is the value of the cash held by the company toward the end of an accounting period, along with other cash equivalents, such as marketable securities, and short-term deposits.
- Inventory, also classified under current assets, refers to products ready for sale and the raw materials used to manufacture them.
- Accounts receivable, also listed under current assets in the balance sheet, are any amount owed to a company for goods and services delivered.
- Fixed assets are items the business owns, like property, equipment and machinery.
- Intangible assets include trademarks, patents, domain names, copyright, and goodwill. Both fixed and intangible assets are listed under non-current assets.
- Debt is money that the company owes others like banks or suppliers. Short-term loans are listed as current liabilities. Long-term debts like a lease are listed as non-current liabilities.
- Accounts payable refers to the outstanding amounts that the company owes, for instance, suppliers of raw materials or services. Because it’s normally payable within 90 days, it’s listed under current liabilities.
- Underfunded pension plans are plans that do not have adequate funds to pay for current and future retirements.
- Deferred tax liability refers to tax that is owed but has not been paid yet.
Owner’s or shareholder’s equity
- An owner’s or shareholder’s equity is the total assets owed to owners or shareholders after all debts or liabilities have been paid, should the company be liquidated.
- This segment of the balance sheet includes the 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.
What is an income statement?
An income statement is a financial statement that provides a summary of a company’s financial performance over a specific time. Also known as the profit and loss statement, it reports the financial matters such as revenue earned, goods sold, overheads, and all expenses paid. The difference between the two numbers clearly shows if the company operated at a loss or made a profit.
An income statement usually covers the financial performance over a year, but companies may, for various reasons, draft quarterly or monthly income statements.
What does the income statement tell us?
An income statement shows, at a glance, whether a business was profitable over a certain period. If total revenue is greater than total expenses, this means the business was profitable. If total revenue is more than the total expenses, the business is operating at a profit.
What is the purpose of an income statement?
The profit and loss statement is a key document that informs major business decisions. Investors and lenders use it to compare the financial performance during different periods in order to determine the long-term direction of the company.
Management and investors use it to make decisions about products or services, such as increasing production, pushing sales, or targeting a different segment of the market. It can also be used to make decisions about the future of a department or the future of the company itself. Monthly and quarterly income statements can be used to guide-short term strategy.
Research analysts and auditors use income statements to compare a company’s quarter-on-quarter and year-on-year performance.
What’s included in an income statement?
The income statement shows revenue, expenses, gains and losses, but does not include cash, cash flow or, non-cash sales.
- Revenue: The money earned through normal business operations, representing the total income generated during the income statement period, i.e., a year, quarter, or month. It includes revenue generated from the core activities of a business and non-operating revenue, such as dividend or interest income.
- Expenses: This is the amount it costs the company to operate, such as the cost of goods sold (COGS), in other words, the cost of materials and labor to produce products and services. General administrative costs essential to operate the business and depreciation or amortization of assets also fall under expenses. Depreciation is the loss in value of physical assets, such as machines, equipment, or vehicles over time. Amortization applies to the depreciation of an intangible asset over time.
- Realized gains and losses (also referred to as “other income”): Are gains resulting from selling an asset like real estate for more than the original purchase price. A realized loss occurs when an asset is sold at a loss.
- Net income or loss: A net profit or loss is what remains when the added realized gains and expenses and realized losses are subtracted from each other. Net income represents the profit or earnings after deducting all expenses from revenue. A net loss occurs when total expenses exceed the revenue produced over a period of time. A net loss can be the result of such factors as increasing operational costs, targeting the wrong audience, and new competitors.
What are the differences between a balance sheet and an income statement?
To better understand the two financial documents, let’s look at the differences between the balance sheet vs. income statement:
- The two documents provide different information. The balance sheet shows a company’s financial position at a specific point in time; the income statement is an overview of a company’s financial performance over time. The balance sheet shows what a business owns, and the income statement shows how a business has been performing, whether at a loss or profit.
- They list different items. The balance sheet lists assets, liabilities, and shareholder’s equity. The income statement lists revenues, expenses, and gains and losses.
- The two documents have different purposes. The balance sheet is typically used to determine if the business can meet all its financial obligations with current resources. The income statement is used to gauge a company’s profitability and as a basis for important business decisions.
- Creditors and management use them differently. Banks and creditors are more interested in the balance sheet because they want to ascertain creditworthiness and the availability of assets as collateral. Business owners, management of large companies, investors, and shareholders focus on the income statement to gauge the performance and future prospects of a company.
- Financial analyses are done differently for different purposes. In the case of a balance sheet, the financial health is determined using ratios like debt-to-equity ratio and return on shareholder’s equity. In the case of a balance sheet, the financial performance is determined through ratios, such as gross margins and operating margins.
Are there any similarities between an income statement and a balance sheet?
The balance sheet and income statements both play a role in illustrating the financial position and future prospects of a company.
The two documents are closely related so that errors in one are reflected in the other.
The income statement and balance sheet follow the same accounting cycle, whether produced monthly or yearly. The income statement is created before the balance sheet.