When running a business, five types of financial statements are part of running a business well. They are the following: (1) the balance sheet; (2) the income statement; (3) the statement of cash flows; (4) the statement of changes in capital; and (5) the statement of financial position. Of these five financial statements, the balance sheet, income statement, and cash flow statement are considered the “Big Three,” the top three financial statements that the owner of any business, regardless of size, should use to be very familiar with. And when you look at the big three, the importance of a healthy balance sheet and income statement cannot be underestimated.

For any business owner, both the balance sheet and the income statement are important documents in their own right. For many companies, there is often a strong relationship between the balance sheet and the income statement: when the income statement is strong, the balance sheet tends to be as well. Because of this correlation, many business owners confuse the two documents, but be warned: discrepancies between the balance sheet and income statement are possible, and if you’re not familiar with the difference in these documents, this can cause a big headache. For this reason, at FinancePal we have decided to break down the differences between the balance sheet and the income statement.

What is a balance sheet?

First, the balance sheet is a financial statement that shows the balance between what a business owns and what it owes. This document explains the assets of a company along with its liabilities and its share capital. This can be deduced from the title of the document, but the balance sheets must be, well, balanced: total assets must equal total liabilities and shareholders‘ equity.

What is included in a balance sheet?

As mentioned above, the balance sheet shows all assets, liabilities, and shareholders’ equity.

Assets – Assets can include cash, property, and inventory. Typically, these items are placed in order of liquidity; Assets that can be most easily converted to cash are placed at the top of the list.

Liabilities – Liabilities include things like taxes, loans, wages, accounts payable, and any other debts or financial obligations.

Shareholders’ Capital – Shareholders’ capital is the amount of money originally invested in the business, as well as retained earnings less distributions made to owners.

The basis of the balance sheet is a simple and intuitive formula:

Assets = Liabilities + Capital

The reasoning is simple: A company must pay off all of its assets, either by borrowing (a liability), using an investor’s money (issuing shareholder equity), or using retained earnings.

An example in which this formula is applied is the following: The owner of Company A decides to go to the bank and request a loan of $5,000 for 5 years for his business. Once the loan has been obtained, it will be reflected on both sides of the balance sheet, since the loan will increase both the asset and the liability by $5,000.

If the owner of company A also takes $6,000 from investors, this amount will also be added to both the assets column and the shareholders’ equity column.

After both trades are complete, assuming nothing else has changed, of course, assets will have increased by $11,000 while liabilities ($5,000) and stockholders’ equity ($6,000) will also add up to $11,000.

Assets (+$11,000) = Liabilities (-$5,000) + Shareholders’ Equity (-$6,000)

For the balance sheet to be considered “balanced,” the company’s total assets must equal total liabilities plus equity.

The categories of a balance sheet can be further broken down into current assets, non-current assets, current liabilities, and non-current liabilities.

Current assets include assets that the company expects to consume or convert to cash (liquidate) in the next 12 months. It typically includes assets such as stocks with regular turnover and borrowed loans.

Non-current assets include all assets that are not expected to be consumed or liquidated in the next 12 months. This includes assets such as equipment, vehicles, and buildings.

Current liabilities include liabilities that are expected to be paid in the next 12 months. These liabilities typically include credit card debt, taxes owed, short-term loans, and stock purchases.

Non-current liabilities typically include liabilities that are not expected to be settled in the next 12 months. Typical non-current liabilities can be mortgages on buildings and long-term loans.

The balance sheet shows how a business puts its assets to work and how those assets are financed based on the liabilities section. You must make sure they are updated every month, as banks and investors will look at a company’s balance sheet to see how it is using its resources.

What is an Income Statement (Profit and Loss Statement)?

An income statement (also known as a profit and loss account or profit and loss statement) is a crucial business document used to report a company’s financial results, illuminating a company’s income and expenses over some time. of specific time.

What is included in an income statement?

Income statements include vital cash flow information such as revenue, cost of goods sold, and operating expenses over a given period. They also show the net income or loss resulting from that particular period.

Income statements typically have five main components: (1) revenue; (2) cost of goods sold (COGS); (3) gross profit; (4) expenses; and (5) net profit.

An operating expense is an expense such as payroll, rent, and non-capitalized equipment; basically, any expense related to day-to-day operations. A non-operating expense is not related to the main operations of the business, such as depreciation or interest charges.

Similarly, operating income is the income generated by the main activities of the business, while non-operating income is the income that does not belong to the main activities of the business.

Income statements are especially useful for tracking key performance indicators (KPIs) such as break-even, gross and net profit margins, debt ratios, liquidity ratios, working capital ratios, return on investment (ROI), inventory turnover, accounts receivable, accounts payable turnover, and expense ratios, among other performance indicators.

What is the difference between a balance sheet and an income statement?

It is important to note all the key differences between the income statement and the balance sheet so that a company can know what to look for in each.

The first and most important difference between the two documents is the indication of performance. The balance sheet does not indicate performance but merely shows how the company uses its resources. The income statement can give a much clearer picture of how a company has performed over some time.

The second key difference between the balance sheet and the income statement is time. The balance sheet is more of a snapshot; It shows what a company owns and owes at any given time. Instead, the income statement shows the total income and expenses during a specific period.

The third key difference is what each document reports. The balance sheet reports assets, liabilities, and equity. The income statement presents information about cash flow, such as income and expenses.

The fourth key difference between the balance sheet and the income statement is the way companies use each document. Businesses use the balance sheet to determine if the business has enough assets to meet its financial obligations. Banks use the balance sheet to keep track of how the company uses its resources. For its part, the income statement is mainly used to assess performance and shed light on what, if any, financial issues need to be corrected.

The fifth key difference between the two documents is how they affect creditworthiness. Lenders use the balance to judge resource utilization and help them determine whether to extend more credit. Income statements, on the other hand, are used by lenders to decide whether the company is making enough money to pay its obligations.

What are the similarities between an income statement and a balance sheet?

Although the income statement and balance sheet have many key differences, there are also a couple of key similarities between them. Both are considered part of the three main financial statements, along with the statement of cash flows. These three documents are essential for the proper functioning of any company. Also, even though the balance sheet and the income statement are used differently, both are used by creditors and investors to help them decide whether or not to become financially involved with the company.

Any business owner needs to know the differences between the income statement and the balance sheet to better synthesize the vital data they provide. But while these two documents provide different sets of information, it’s clear why both statements play an important role for banks and investors, as they provide a strong indication of a company’s current and future financial health.