Balance sheet vs P&L statement - What is the difference?

Financial statements of a company


There are three important financial statements of a company



Balance sheet


P&L statement/ Income statement


Cash flow statement



Within these categories of different documents, each one serves a separate function in analyzing the company’s financial performance. A balance sheet helps an organization get an overview of its financial position at a particular point in time.


The function a P&L statement is that of showing all the expenditures and revenue during a particular period. This helps in getting information to understand whether decreasing costs, increasing revenue, or doing both will generate a profit.


A cash flow statement gives a detailed view of the inflow and outflow of cash within a business during an accounting period. An accurate cash flow statement will show how the business operates in the short and long term.


The debate between a balance sheet vs P&L statement often comes up when discussing the utility of each financial document and how they help a company analyze its financial health.

What is a balance sheet of a company?


A balance sheet is a financial document that can be seen as an overall view of what your company owns and what your company owes at a certain point in time.


The name ‘balance sheet’ is derived from the fact that the assets a company owns should always be equal or in balance with the liabilities that the company has.


If the balance sheet is to be summed up in an equation, this is how finance professionals define it


Assets = Liabilities + Equity


The balance sheet is a document that is usually created by companies at the end of a financial year.




Two sides of a balance sheet


1. Equity and Liabilities - These are the list of all liabilities of a company or the amount they owe other stakeholders like investors and employees.


2. Assets - These are all the resources of positive economic value owned and controlled by the business.

Components, format and importance of a balance sheet


A balance sheet mainly shows 3 types of information about the company, namely assets, liabilities, and equity.




1. Components


Assets - It shows the assets that a company currently owns. An asset in financial accounting terms is any resource that is owned and used by an organization.


Examples include fixed & current assets, Cash, inventory, securities, accounts receivables, etc.



Current assets - Current assets of a company are those assets that can be converted into cash within a fiscal or financial year. This can happen either by exhausting, selling, or consuming the asset depending on what it is. 



Fixed assets - Fixed assets are those assets of a company that are not easily converted into cash. These assets are used over a more extended period of time.


Examples of such assets include a factory that has been set up for manufacturing, machinery & equipment, and buildings. Fixed assets differ from current assets in the sense that they cannot be liquidated easily.



Long-term investments - Investments that a company makes with the intention of holding it for more than a year fall under the long-term investments category under the assets section on a balance sheet. A few examples include real estate, bonds, and stocks.



Accounts receivable - Any amount of money that your company is expecting from a client or customer falls under accounts receivable.



Securities - These are assets that a company can buy and sell on a public stock exchange and liquidate easily within a year. These securities fall under current assets.



Inventory - If your business is one that sells physical products, then the inventory you produce and store falls under assets in a balance sheet.



Cash & cash equivalents - The most liquid asset that companies have are their cash, cash reserves, and other equivalent assets. 



Liabilities - Any amount or form of money that the company owes to others or has taken as a form of loan is considered a liability. Examples include long-term & short-term liabilities, debt, accounts payable, etc.


Within a balance sheet, a company bifurcates its liabilities into current and non-current or long-term liabilities. Any liability that your company has to fulfill within a year falls under current liabilities.


On the other hand, non-current liabilities are those that your business has to fulfill after a year. Adding both of these gives an organization its total liabilities.



Shareholders equity - The amount of money that is invested by shareholders in the company at a given point in time is known as shareholders equity.




2. Format


There are two major ways of making a balance sheet known as a horizontal balance sheet and a vertical balance sheet. The difference between both is pretty straightforward.


The horizontal balance sheet denotes the assets and liabilities next to each other in a horizontal fashion whereas the vertical balance sheet portrays the assets and liabilities with the upper column showing all assets and the lower column showing all liabilities.




3. Importance


As one of the three most important financial documents, a balance sheet helps the company and relevant stakeholders understand its financial position.


It does this by showing what the company owns at a certain point in time in comparison to what it owes. 


All of this information on a balance sheet is used by investors to partially analyze and understand the situation that the business currently is in.


From a bank’s perspective, the balance sheet will help them see whether the business qualifies for further loans or credit.


And from an investor's perspective, it helps them see where their money will go and the kind of returns they might be able to expect in the future.


From a business owner’s point of view, the balance sheet informs about the financial standing and gives an idea about how the organization is currently performing and how it should move forward.


Analyzing and understanding this financial document is critical to making sure that your business is not failing.


Generally speaking, when you calculate the ratio between your assets and liabilities and it is less than 1:1, then your company is considered to be at risk of bankruptcy.

What is a profit and loss statement?


When talking about the balance sheet vs P&L statement, the profit and loss statement is a financial statement that shows all the expenses, costs, and revenue a business has generated in a given period of time.


By subtracting all the expenses from your total revenue, you will be able to work out if your business has generated a profit or a loss in that given period.


To put it simply, when your revenue is higher than your expenses, then you have made a profit. But when your expenses are higher than your revenue, then you have incurred a loss.


The time frame within which a company prepares its profit and loss statement differs from one organization to another. It can be prepared on a monthly, quarterly, or annual basis.

Components, format and importance


1. Components of a P&L statement


Profit & Loss - The bottom line of your income statement will tell you whether your business has made a profit or incurred a loss for that particular period of time.



Revenue - The total amount of money that is earned by a business during the period of time being calculated by the income statement is denoted differently based on the type of business you have.


For example, if your business sells tangible products, then the revenue generated from it can be written as ‘Product Sales’. On the other hand, if your business is a service provider, then the revenue you generate can be written as ‘Services Rendered’.


This is a small but crucial difference for the company to denote so that there is more detail and clarity on what are all the individual aspects of the business that a stakeholder is reading when going through the P&L account.


 

Expenses - There are many different types of expenses that a company incurs in the pursuit of building its business. Costs can be broadly classified into two types namely direct costs and indirect costs.


Direct costs are those that can be directly linked to the production and distribution of goods or services. These are variable costs meaning they change depending on the number of goods sold as they are directly linked to how many goods you sell or how many services you provide.


Direct costs often increase in the proportion of sales you make. On the other hand, indirect costs are those that cannot be directly linked to the sale of goods or the services you provide. In the accounting world, these are also known as overhead expenses.


In comparison to direct costs that are variable in nature, most indirect costs are fixed. These costs remain constant over a longer period of time and have a direct effect on the number of sales you make.


There are cases where some indirect costs like rent and salaries are not completely fixed and can have an effect on your sales but still not be directly linked to it.




Some of the common costs that most companies list on their profit and loss statements include:




1. Costs of goods sold/cost of services - Any amount of expenditure on the production of goods or services that are sold is known as the cost of goods sold/cost of services.


Examples include labor and the cost of procuring raw materials and transforming them into finished goods.


2. Administrative expenses - Any cost that is associated with administrative work or management such as hiring and wages fall under administrative expenses.


3. Interest and selling expenses - Any expense that an organization had to pay in the form of interest or in the form of selling costs is also included in the profit and loss account.


4. Cash dividends per common share - Cash dividends refer to dividends that a company pays its shareholders in the form of cash. The amount is paid from the business’s current earnings or the profit it has accumulated as opposed to other types of dividends such as stock dividends.




2. Format


While there isn’t a fixed format that every company must follow when preparing their P&L statement it should definitely include the revenue, returns, the net revenue, the cost of goods sold or services rendered, the gross profit.


Some of the other things to be included are rent, and office expenses, interest expenses, advertising and promotion expenses, salaries, depreciation and amortization, SG&A expenses, income tax, earnings before interest and tax, earnings after tax, and the net earnings.




3. Importance


The profit and loss statement is important because it shows the revenue, expenses, and if the company has made a profit or loss. In short, it shows how profitable a company is in a given period of time.


Not only that, but you can use the current month’s statement to compare the previous month’s statement and see the movement that has occurred in each line item.


You can do this to even compare the company's performance this quarter compared to last quarter, this year compared to last year, and so on. 


For accounting professionals, this data becomes crucial to understand the performance of the business and derive insights that inform stakeholders why the company is profitable or is facing a loss.

Balance sheet vs P&L statement - Key differences


When talking about the balance sheet vs P&L statement, both are important financial documents of a company that relays insightful information about the company's financial health and overall stability and growth.


But the difference between p&l and balance sheet is that both these documents do it in a different way.




Balance Sheet


The balance sheet gives a snapshot of the company’s financial standing at a certain point in time. A key difference between the balance sheet and the profit and loss statement is the time when they are prepared by accountants.


A balance sheet is usually prepared at the end of a year or on the last day of the accounting year while the profit and loss statement is created by accountants in shorter business cycles such as each quarter or every month.


A balance sheet also majorly represents a broad overview of financial information such as investments, assets, cash and cash equivalents, accounts payable, inventory, and equity.




Profit and loss statement


A profit and loss statement provides more detailed financial information most of which is not a part of the balance sheet such as the revenue or income, cost of goods sold or services rendered, administrative expenses, dividends per common share, etc.


The P&L statement tells whether the company made a profit or loss during the given period the statement shows.


This information is also used to compare it with past profit and loss statements to analyze whether the company is growing consistently, making a loss consistently, or is going through ebbs and flows.

Step-by-step process of creating each report and docs considered


A balance sheet vs P&L statement has different line items needed to prepare each document. A P&L is always prepared before the balance sheet due to its reliance on the value of the net profit or loss.


Mentioned below are the steps you need to complete to prepare each document:




Profit and Loss statement


The first step to create your profit and loss statement is to define the period for which you want to calculate the same. Be it a month, quarter, or a year depending on who all the statement needs to be shown or reviewed by. 


The first piece of information you need to start creating your profit and loss statement is your total revenue. The next thing you need is the cost of goods sold or the cost of services rendered and subtract it from your total revenue.


This will give you a gross profit or loss amount. Once you have the gross profit or loss amount, you must then subtract all other indirect costs from it.


These indirect costs most often are fixed in nature such as rent, employee salaries, legal costs, administrative expenses, and other operating expenses.


Once you subtract all these different indirect costs from the gross profit or loss, the amount you will end up with is your company’s operating profit or loss.


Any interest paid is subtracted from the operating profit that will give you your earnings before income tax. Once you subtract the tax amount you owe, you will finally have your net profit.




Balance Sheet


Before creating the balance sheet, you need a trial balance. A trial balance is an accounting report that shows the closing balances for all the general ledger accounts at a point in time. 


The trial balance will have all the assets, liabilities, equity, revenue, and expenses listed and you can see whether the debit side of the trial balance matches the credit side.


If the trial balance is in balance then you are ready to prepare the balance sheet. If it is not in balance, then there must have been some error in the double entry of ledger accounts or a miscalculation has happened.


There are two ways of preparing the balance sheet. The simple way and the comprehensive or detailed way.


The simple way of doing it is by adding up all the assets in the trial balance and putting the total amount on the left side of the balance sheet, adding up all the liabilities and noting it on the right side.


And adding up the equity value which includes the revenue and expenses and adding it on the right side of the balance sheet as well. This will give you a brief snapshot of the assets, liabilities, and equity of the company.


The comprehensive or detailed way of doing it is by dividing the assets into current and non-current assets, dividing the liabilities into current and non-current liabilities, and dividing the equity into capital contribution and retained earnings. 


Once you have these individual values categorized as mentioned in the previous step, you can put the values on their respective sides on the balance sheet.


And you will end up with a much more detailed financial picture through the document as compared to just an overview.

What is the relationship between the balance sheet and P&L statement?


When accountants are creating a financial report for their company they cannot just rely on either a profit and loss statement or a balance sheet.


Both these documents along with the cash flow statement are the three most important financial statements that give a clear picture of the company’s current financial position and health. 


Both the balance sheet and the income statement have a relationship with each other that makes preparing each accurately extremely important.


When we talk about the order in which they are created, a profit and loss statement is always created before a balance sheet.


This is so because certain details like the net profit or loss that are calculated in the profit and loss statement are needed to balance out the shareholder’s equity in the balance sheet.

Analysis of balance sheet and P&L statement


Balance sheet


A balance sheet can be used to compare the financial health of a company on two different dates and see how it has improved over time. A balance sheet can help calculate the following financial ratio:



1. Current ratio - When you divide the current assets by the current liabilities you get the current ratio. This ratio measures the ability of an organization to pay its short-term obligations.



2. Quick ratio - Current assets minus inventory divided by a company's liabilities gives the quick ratio. This ratio tells a company's ability to pay off its current liabilities with cash or cash equivalents.



3. Debt-to-equity ratio - This ratio is used to calculate a company's financial leverage. The debt-to-equity ratio is calculated by dividing your total liabilities by the total shareholder’s equity. A good debt-to-equity ratio is anything lower than 1. A negative value or a ratio higher than 2.0 is considered risky.




Profit and Loss statement


The net profit or loss that you calculate using a P&L statement is a relation between your total revenue, costs, and expenses. That means you can use this data to analyze what part of the business needs to be reduced or increased in order to improve financial health.


If your costs are more than revenue, you will obviously incur a loss. So you must find ways to reduce costs and increase revenue at the same time. Using the p&l statement you can calculate the following financial ratios:



1. Gross Profit Ratio - The gross profit ratio or gross margin is calculated using this formula


  • Gross Margin = Revenue - COGS(cost of goods sold)/Revenue

This tells you how much gross profit your company has made after paying for all the direct costs of doing the business.



2. Operating Ratio - This ratio is used to measure the efficiency of a company's management by dividing its operating expenses by the net sales. 




3. Operating Profit Ratio - This ratio defines the relationship between the operating profit and net sales. 


Operating Profit Ratio = Operating Profit/Net Sales x 100

Generally, an OPR of 20% is considered to be good and anything below 5% is low.




4. Net Profit Ratio - The net profit ratio or the net profit margin ratio is important for investors to see whether the company is generating enough profits to cover all its costs. 


Net Profit Ratio = Net Income/Net Sales x 100

How to understand the overall financial condition of your business


Determining profitability & performance of the company

When it comes to understanding profitability, the profit and loss statement is the one to look for.


Not only does it help to understand the relationship between revenue and costs, but it also looks at the profit or loss of business across a period of time using past P&L statements.


The movement in all the line items of an income statement indicates to relevant stakeholders how the company is performing and whether it is moving towards profitability or not.




Understanding financial health

While the p&l statement helps a company measure financial performance over a period of time, a balance sheet can help you understand the financial health of a company on two given dates.


By comparing the broader financial aspects of a company such as its assets, liabilities, and equity.




Measuring accuracy for financial transaction records

Keeping all the financial information accurately is important for accountants to provide assurance to investors and stakeholders about the company’s financial health.


Since the P&L statement can be created in small and short business cycles of even a month, it can help companies keep track of data regularly without any complications or errors.




Cost & expense efficiency of the company

Depending on how much profit or loss your business is generating, you will be able to understand the efficiency of your costs and expenses.


If costs and expenses are higher than your total revenue, then you need to figure out a way to decrease these costs as they are not contributing to your revenue in a positive manner.

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