Balance Sheet vs. Profit and Loss Account

In the world of finance and accounting, understanding financial statements is crucial for any business. For small business owners and contractors who have just started out, staying on top of your business finances and documents can be challenging. Two vital financial documents that play an important role in assessing a company's financial health and performance are the Balance Sheet and Profit and Loss Account (P&L). These documents provide insights into different aspects of a company's financial position, helping stakeholders make informed decisions. In this article, we will understand the specifics of a Balance Sheet and a Profit and loss Account, exploring their characteristics, differences, and how they interrelate.

A Balance Sheet is a snapshot of a company's financial position at a specific point in time. It comprises three main components: assets, liabilities, and equity. Assets represent what a company owns, such as cash, equipment, or inventory. Liabilities show what a company owes to others, such as loans or accounts payable. Equity is the leftover amount in the assets of the enterprise after deducting liabilities.

The Balance Sheet follows the accounting equation: Assets = Liabilities + Equity. 

It provides a clear view of a company's financial resources and how those resources are financed—showing the company's overall financial health at a particular moment.

The balance sheet is typically completed at the end of a month or a financial year. It is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders' equity.

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.

1. Assets: Assets are the economic resources owned and controlled by a business entity that provide potential future economic benefits. These resources are tangible or intangible and can be used to generate revenue or support business operations. Assets are resources that you own and can be sold, and are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment. Assets are typically categorized into two main types: current assets and non-current assets.

Current Assets: Current assets are assets expected to be converted into cash or used up within a year or an operating cycle of the business. Examples include cash, accounts receivable, inventory, and prepaid expenses. These assets facilitate day-to-day operations and help in meeting short-term obligations.

Current assets are typically listed in the following order:

• Cash and cash equivalents
• Marketable securities: Stocks, bonds and other securities that are bought and sold daily
• Accounts receivable: Money your customers owe you for your goods and services
• Inventory
• Prepaid expenses: Expenses that are paid or in advance, such as rent, salaries, utility expenses and small business insurance.

Non-Current Assets: Non-current assets, also known as long-term assets or fixed assets, are expected to provide economic benefits to the business for more than a year. This category includes property, plant, equipment, intangible assets, investments, and long-term receivables. Non-current assets support the company's long-term growth and operations.

Non-current assets are generally listed in the following order:

• Long-term investments: Assets that a business intends to hold on to for more than a year, such as stocks, bonds, mutual funds, cash or real estate assets.
• Fixed assets: Property or equipment that a company owns, and uses in its day-to-day operations for income generating activities. These include machinery, equipment, buildings and land.  
• Intangible assets: Non-physical assets such as goodwill, copyrights, patents, intellectual property and customer lists. Intangible assets are generally listed on the balance sheet if they are acquired, and not developed internally.

2. Liabilities: Liabilities represent a company's legal obligations or debts owed to external parties, such as creditors, suppliers, or lenders. These obligations require the company to make future payments or provide goods or services. Liabilities can be categorized into two main types: current liabilities and non-current liabilities.

Current Liabilities: Current liabilities are obligations expected to be settled within a year or an operating cycle. Examples include accounts payable, short-term loans, accrued expenses, and current portions of long-term debt. Current liabilities are settled using current assets.

Current liabilities include:

• Interest payable
• Salaries payable
• Accounts payable: Money that a business owes to its creditors
• Dividends payable
• Accrued expenses: Expenses that have been incurred, but aren’t yet paid
• Income taxes owed

Non-Current Liabilities: Non-current liabilities are debts or obligations expected to be settled over a period longer than a year. This category encompasses long-term loans, bonds, deferred tax liabilities, and other long-term obligations. Non-current liabilities represent the long-term financial commitments of the company.

Long-term liabilities include: 

• Long-term debt: Loans and other liabilities that have a maturity of one year or longer, such as bank loans, debentures and mortgages
• Capital leases
• Bonds payable
• Pension liabilities
• Customer deposits

3. Equity: Equity, also known as shareholders' equity or net assets, is the remaining amount in the assets of the company after deducting liabilities. It represents the owners' claim on the company's assets. Equity can be further divided into 3 components:

1. Share capital: Owner's equity comprises the initial investment made by the company's owners (commonly known as shareholders) and any additional capital shared into the business. It also includes retained earnings, which are the cumulative profits reinvested back into the business over time.
2. Retained Earnings: Retained earnings are the portion of net income that a company retains and reinvests in the business instead of distributing it to shareholders as dividends. It contributes to the growth and expansion of the company.
3. Paid-In Capital: Also known as contributed capital, paid in capital refers to capital that is contributed to a company by investors in exchange for newly issued shares of its capital stock. It includes share capital and additional paid-in capital.

The balance sheet lets a business owner and investors see what the company owns and owes, and 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’s efficiency and shows how well it can meet its short-term obligations. 

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. 

Below listed are the reasons why a Balance Sheet is critically important:

• Financial Health Assessment
• Liquidity Analysis
• Debt and Equity Ratio Analysis
• Investment Decisions
• Creditworthiness Evaluation
• Trend Analysis
• Strategic Decision Making
• Reporting and Transparency

Balance sheet templates:

• Balance sheet template #1
• Balance sheet template #2
• Balance sheet template #3

A Profit and Loss Account, also known as an Income Statement, is a financial statement that presents a company's revenues, expenses, and profits or losses over a specific period. It helps to evaluate a company's operational performance during a specific timeframe, typically a month, quarter, or year.

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.

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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.

Below listed are some reasons why a profit and loss statement is important:

• Performance Evaluation
• Revenue and Expense Analysis
• Profitability Assessment
• Investment Decision-Making
• Budgeting and Forecasting
• Lender and Creditor Evaluation
• Tax Planning and Compliance
• Performance Comparison

P&L templates:

• P&L template #1
• P&L template #2

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