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Accounting 101 for Entrepreneurs: Your balance sheet and P&L explained

The basics of a balance sheet and P&L explained

Created by :
Chris Andreou
Charlie Bailey
Christian Faires

on

January 16, 2020

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For small business owners and freelancers who have just started out, staying on top of your business finances and documents can be daunting. Here’s where our article comes in, so you can quickly get a grip on the basics.

What is a balance sheet?

A balance sheet provides a snapshot of the financial condition of a company, showing how much it owns (assets), owes (liabilities) and the amount that is left over for its owners (owners’ equity) at a specific point in time. 

The balance sheet is typically completed at the end of a month or a financial year. It is comprised of three main elements:

  • Assets: These are resources that you own and can be sold. Examples include cash, vehicles, inventory and equipment. 
  • Liabilities: These are your business’ legal debts or financial obligations. Examples include loans, accounts payable and salaries payable. 
  • Owners’ (or shareholders’) equity: This refers to the owner’s share of the assets of a company. It includes the share capital (the amount that a company’s owners or shareholders invest in the business) and retained earnings (funds that are retained in the company’s accounts).

The balance sheet is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders’ equity.


Balance Sheet
Balance Sheet

Assets are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment. 

Liabilities are listed in order of maturity; current liabilities, which will come due within a year are listed above long-term liabilities. The latter refers to liabilities that will remain outstanding for longer than one year. 

The total sum of all assets, less a business’ total liabilities is equivalent to the owners’ equity. This represents the amount that would be available for a business owner to draw out.

Why is a balance sheet important?

The balance sheet lets a business owner and investors see what the company owns and owes, and to understand its net worth. It also indicates the financial health of a business. 

For example, a balance sheet that shows a negative balance in owners’ equity indicates that liabilities exceed assets. This can be a warning sign that the company is in a bad financial situation, and should prompt business owners to dive deeper, and uncover the causes for the negative balance. 

A balance sheet can also be used to calculate important financial ratios. One example would be the working capital ratio, which is obtained by dividing the current assets by current liabilities. This ratio measures a business’ efficiency, and shows how well it is able to meet its short-term obligations. 

And for small business owners seeking external financing, the balance sheet —along with financial statements like your cash flow and P&L—are required documents when you apply for a bank loan. 

Balance sheet templates:

example of a profit and loss statement

What is a profit and loss account?

The profit and loss account (P&L) is a financial report that shows the revenue, expenses and profit or loss of your company over a specific accounting period. 

This period can be a month, a quarter or a year. A P&L is also commonly referred to by other terms, such as the income statement, statement of operations, financial results statement and earnings statement. 

A P&L is comprised of the following key elements:

  • Sales or revenue: The amount that your company earns through the sale of goods or services.
  • Cost of goods sold (COGS): The total amount of all costs involved in selling a product during a specified period of time. 
  • Gross profit: Also known as the gross margin, the gross profit refers to a business’ profit before the operating expenses, taxes and interest payments are taken into account. It is calculated by deducting the COGS from the total sales or revenue. 
  • Operating expenses: This refers to expenditures that a company incurs in performing business operations that aren’t directly related to the productions of goods or services. Some examples include salaries, utility payments, administrative expenses and rent.
  • Net profit or loss: The net profit or loss is obtained by deducting total expenses from gross profit.  

Why is the profit and loss account important?

The P&L is a key financial statement in a business plan, as it quickly shows how much money your business has made or lost. 

What’s important is to compare your P&L across different accounting periods. In doing so, you’ll be able to identify business cycles and trends—such as the peak and trough periods that occur across the year, or aspects of your business that generate the most profit or costs. 

You may also identify changes that are not immediately apparent, such as periods where your expenses are growing at a faster rate compared to your revenue. With these insights, you’ll be better-positioned to make improved business and financial decisions. 

And lastly, information from your P&L can also be used to calculate metrics that are important indicators of your company’s financial health. These include the operating ratio, gross profit margin and net profit margin.

P&L templates:

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