Your Balance Sheet and Profit & Loss explained

Chris Andreou

December 28, 2020

profit and loss account guide

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Small Business Accounting

Balance Sheet vs Profit & Loss Explained

For small business owners and contractors 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 divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders' equity.

Profit and loss example

The balance sheet comprises of three main elements: assets, liabilities and owners' (or 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.

Assets

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. 

They are categorised into current assets, which represents all assets that are convertible to cash in less than a year, as well as non-current assets. The latter refers to long-term investments for which the value will not be realised within the accounting year.

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 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.

Liabilities

Liabilities are your business' legal debts or financial obligations.

They 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. 

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

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

Owners' (or shareholders') equity

As its name suggests, owners' equity 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 owner’s equity section of a balance sheet will include:

  • Share capital: Funds that are raised by a firm in exchange for common or preferred stock
  • Retained earnings: Profits that a firm has earned to date, after deducting dividends or other distributions paid out to investors
  • 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.

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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:

What is a Profit & 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 a Profit & 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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