As a business owner, the income statement and balance sheet are both vital business documents. However, they are not one and the same, although a good income statement usually translates to a good balance sheet. In some cases, a business may have a great income statement but not a good balance sheet. Sadly, many business owners mix up these two documents, wondering what the difference is between the two.
A balance sheet and an income statement are fundamentally two separate documents. And we’ll be looking at them both to see how they differ from and relate to each other.
What Is a Balance Sheet?
A balance sheet is a run-through of a company’s assets and liabilities at a given point in time. It is a financial statement that covers the company’s assets, its liabilities, and the investor’s equity. The balance sheet shows a company's financial position at a given time and shows its net worth. The balance sheet is used along with other financial documents to make analysis and financial decisions.
The Balance Sheet: What Does It Cover?
The balance sheet covers three things, primarily: assets, liabilities, and equity. They are usually arranged in order of liquidity, with the easiest to convert topping the list.
Assets include cash and cash equivalents, accounts receivable, inventory, and property.
Cash and cash equivalents: this describes the cash value owned by the company. It also includes cash equivalents like marketable securities.
Accounts receivable: this refers to the debt owed to the company for goods or services already delivered. This is included in the current assets section of the balance sheet.
Inventory: finished goods ready to be taken to the market and raw materials in the store are inventories and are accounted for in current assets.
Property: Plants, trademarks, and copyright belong here. They are the most illiquid of the company’s assets.
Liabilities are the company’s debts. It includes accounts payable, loans, pending taxes, etc.
A company’s debt is the total amount owed (to banks, lending services, etc.). Debts could be short-term (current) or long-term (non-current) liabilities.
Accounts payable: this includes the money owed to suppliers, vendors, or outsourced partners in the production process. These debts are short-term and considered current liabilities.
Pending taxes: this is the company’s deferred tax liability, i.e., tax due but unpaid.
Equity: The sum of money initially invested in the company, and also net earnings minus any payments made to owners, is referred to as equity.
The balance sheet is basically a balance with two sides. That is, assets = liabilities = equity.
The balance sheet portrays how a firm uses its assets and how those assets relate to the company's liabilities. It is vital to keep the balance sheet updated.
What Is an Income Statement?
An income statement is a financial document that depicts a company’s account health over a given time period. It is also known as the profit and loss statement (P&L statement) or an earnings statement, and it shows the company’s expenses and revenues over a period of time.
The income statements are one of the key documents tendered by a public limited liability company periodically. The P & L statement gives an insight into the company’s profitability or lack thereof. It also shows its income sources, budget, and expenses.
The income statements are especially important because they show the company’s trend and possible trajectory, especially when studied across various periods. As such, investors pay special attention to a business's financial statements when deciding whether or not to invest. The P & L statement also gives an experienced financial analyst deep insights into the company’s profitability relative to its sales and expenses.
Income Statement: What Does It Cover?
The income statement primarily accounts for revenue, expenses (including the cost of goods sold), and net income or loss.
Revenue is the total amount earned by the company over a given time period. A company’s revenue may be grouped as operating revenue (from the company’s primary operations or production) and non-operating revenue (from other sources that are not directly related to production).
Other income includes gains gotten from non-recurring sales. For example, when a property is sold, or an asset is disposed of,
Expenses: this refers to all the costs incurred during the production process. It includes the cost of labor, raw materials, and administrative costs.
Net income/loss: This is what is left after the total expense has been subtracted from the gain realized and is also referred to as the bottom line.
8 Steps to Prepare an Income Statement
Step 1: Determine your reporting period
The first step in preparing your financial statement is to decide on your reporting timeframe. You may choose to prepare your financial statements monthly, quarterly, or annually.
Step 2: Calculate the total revenue
Now that you have a reporting period in mind, it’s time to calculate the total revenue your business generated during that period.
Step 3: Determine the Cost of Goods Sold
Next, determine the total cost of goods sold. Consider all of the direct and indirect costs that contributed to your revenue, i.e., all of the costs associated with producing and selling your products or services. The cost typically includes labor costs, raw material expenses, distribution costs, and other production-related costs.
Step 4: Determine your gross profit
Next, calculate your gross profit by subtracting the cost of goods sold from your total revenue.
Step 5: Calculate your operating expenses
After calculating your gross profit, it’s time to determine your operating expenses.
Operating expenses refer to costs incurred from doing the business but are not directly related to production. These expenses are not directly influenced by production. For example, your rent is not dependent on the level of production. Operating expenses include rent, utilities, legal fees, etc.
Step 6: Subtract your operating expenses from your gross profit
Now, calculate your income by subtracting the operating expenses from your gross profit. The value obtained is your business' pretax income or earnings before interest and taxes (EBIT).
Step 7: Calculate the interest and taxes
Next, calculate your interest and taxes.
Interest is the cost of borrowing, i.e., what you pay over your owed debts. To calculate this, you must first determine your total debt and interest rate.
Calculate your company’s accrued tax for the reporting period.
Step 8: Calculate your net income
The last step in preparing your income statement is to calculate your net income. To determine your net income, subtract your interest and taxes from your earnings before interest and tax (EBIT). The value obtained is the available amount that can be returned to the business. It could be redirected towards production, kept as a reserve, or used for other purposes.
P & L vs. balance sheet: What’s the difference between the balance sheet and the income statement?
The balance sheet shows a company’s financial status at a specific point in time. An income statement, on the other hand, represents the company’s health over a period of time.
The balance sheet covers assets, liabilities, and equity, while the P & L statement covers revenue, running costs, tax expenses, and net profit/loss.
While the balance sheet doesn’t show a business's performance, the income statement gives more insight into performance.
Usage within the company
Within the company, the balance sheet is used to determine whether or not the company is fit to meet its financial obligations, given the assets available.
The balance sheet and income statement are both important documents, and their relative importance varies depending on who’s considering them. However, the income statement is considered more important than the balance sheet because it is more detailed and gives a better insight into the company’s financial health.
The balance sheet aids in the evaluation of metrics such as the current ratio, debt-to-equity ratio, and return on shareholders' equity. Meanwhile, the income statement helps determine operating margins, gross margins, and price to earnings.
Lenders use the balance sheet to determine whether or not a company is worth credit, i.e., they weigh the availability of property for collateral. Then, investors use income statements to foretell the future prospects of a business.
Do They Have Anything in Common?
Both documents complement each other and are crucial in making financial decisions within a company.
Both documents need to be accurately computed as they make up the core of financial reporting. An error in the balance sheet affects the financial statement and vice versa. So, an error in either will result in overall inaccuracy.
The financial statement and balance sheet both follow the same accounting cycle, with the only difference being that the balance sheet is only prepared after the financial statement has been made.
Both are essential financial documents and rely on each other for effective financial record-keeping.
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