The basics of a balance sheet and P&L explained
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.
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:
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.
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.
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.
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:
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.