Maintaining detailed financial records is just one of many aspects to running a successful business. Good bookkeeping practices can give a business invaluable information on its performance and help guide it to future success. However, not every business owner automatically has a strong understanding of accounting practices and the different types of financial statements a business should maintain. And that’s okay! There are many types of financial statements, but two important types that all business owners should familiarize themselves with are the balance sheet and the income statement.
What is a Balance Sheet?
A balance sheet is a report that shows a company’s financial health at a specific point in time. It reports on three distinct factors: assets, liabilities and equity.
- Assets are what your company owns. This includes cash, inventory, investments, debts owed to the company, and any intellectual property or copyrights. Assets can be separated by “current assets” (assets that can be turned into cash within a year such as cash and inventory) and “noncurrent assets” (assets that can’t be turned into cash within a year such as property and long-term investments).
- Liabilities are what your company owes. This includes debt, taxes, loans, accounts payable and wages. Like assets, liabilities can be separated by “current liabilities” and “noncurrent liabilities.” Current liabilities are debts the company must pay within a year (such as accrued payroll and accounts payable) and noncurrent liabilities are those not required to be paid within a year (such as long-term loans and healthcare and pension liabilities).
- Equity (also referred to as owner’s equity or shareholder’s equity) is the total amount invested in the company by the owner(s) and shareholders.
A balance sheet is divided into two columns with assets in one column and liabilities and equity in the other. At the core of a balance sheet is a simple equation: Assets = Liabilities + Equity. As the name suggests, a balance sheet must be balanced in this way.
Balance sheets are useful for giving a quick overview of a company’s assets and liabilities and whether the company has a positive net worth. The balance sheet is most helpful when used alongside other financial reports like the income statement.
What is an Income Statement?
An income statement shows a company’s financial performance over a specific period. Income statements are typically annual or quarterly reports, though some businesses may opt for monthly or weekly reports. An income statement’s primary purpose is to show whether or not the company made a profit in the reported period – by adding the total revenue and gains and subtracting the number of expenses and losses. If the total revenue is greater than the total expenses, then the business made a profit during that period. If expenses are greater than revenue, then the business operated at a loss for the period.
Businesses can use income statements to keep track of trends in the company’s financial performance to better plan for the future.
Let’s take a hypothetical scenario of a company that produces quarterly income statements. The income statements show a profit for each quarter, however, the total profit gradually decreases each quarter as total expenses continue to increase. The company can then take action to reduce expenses where possible and increase its profitability. Had the company not noticed the trend of increasing expenses on their income statements, that trend could have continued to where its expenses eventually outgrew its revenue.
Balance Sheet vs Income Statement
Balance sheets and income statements both offer valuable information on a company’s financial health, but they differ in a few key ways. Here are five key differences between a balance sheet and an income statement.
- Time Covered: A balance sheet reports a company’s finances for a specific date, such as January 1, 2022. An income statement reports a company’s revenue and expenses over a specific period, such as January 1 – December 31, 2022.
- Owning vs Performing: A balance sheet reports what a company owns at a specific date. An income statement reports how a company performed during a specific period.
- What’s Reported: A balance sheet reports assets, liabilities and equity. An income statement reports revenue and expenses.
- What They’re Used For: A balance sheet is most often used by a company to see if it has enough assets to satisfy its financial obligations. An income statement is used to evaluate the company’s performance to see if it’s profitable.
- Determining Creditworthiness: Lenders and creditors can use a balance sheet for an overview of a company’s total assets. An income statement can serve as proof that a company is profitable and can pay any liabilities.
Because of these differences, balance sheets and income statements are most effective when used together (along with other reports) to give you the best possible overview of your company’s financial situation. Doing so will position you well to make informed decisions about your company’s future.
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Understanding both the intricacies of your business as well as the larger picture of how businesses are conducted will help guide you to success. Standard operating tools such as balance sheets and income statements can be new to aspiring entrepreneurs, but they’re of utmost importance to understand.