As a small business owner, you’ll probably wonder at some point (if not every day!) whether you’re turning a profit or have enough money to pay your bills.
That information can come in handy when making important decisions, like whether to hire more employees, upgrade your equipment or take out a loan. But how, exactly, do you know if your business is doing well, so to speak?
Some tools at your disposal are financial statements. In particular, your income statement and balance sheet are incredibly helpful in figuring out whether you’re in the black or the red. Both statements provide financial information, but they do so differently. Let’s take a closer look.
Income Statement vs. Balance Sheet
An income statement (a.k.a. profit and loss statement) tells you if you’re making a profit or not, while a balance sheet tells you whether you have enough assets to pay your bills and debt. The balance sheet also shows you how much is left over to distribute to owners and shareholders or to put back into the company (all of this is also known as your equity).
Another major difference?
The income statement looks at performance over a given time period (typically a quarter or fiscal year), while the balance sheet gives you a snapshot of your financial health at a specific time.
What Goes on the Income Statement?
Your income statement is a quick way to figure out if you’re making a profit. Here's a template if you're looking to make one. (Just click on "Make a copy" to get started).
The main components of an income statement are revenue and expenses. It starts with your total revenue and then subtracts different expenses to calculate the following types of income: gross, operating, pre-tax, and net.
The income statement shows a list of total expenses for a given period and usually has more than just one expense.
At the end of the income statement, you’ll have your net profit or loss amount, which tells you how much money you made after paying for all expenses. This number is also known as the bottom line since it’s at the bottom of the income statement.
Let’s take a closer look at the lines on the income statement and how you use them to calculate your bottom line.
- Revenue: Total income generated by selling products and services.
- Cost of goods sold (COGS): Total amount of money spent on labor and materials required to make the goods or services.
- Gross profit: Calculated as your company’s revenue minus the cost of goods sold.
- Operating expenses: Also known as selling, general, and administrative expenses, these are costs not directly related to creating goods and services. These include rent, office supplies, and utilities. You’ll also want to add any other income and expenses not related to your business activities. For instance, interest earned on investments or depreciation of an asset.
- Earnings before tax (and interest): All your income minus your expenses EXCEPT for any tax or interest you owe. This is also known as your operating income, or what you’re making off your core business activities.
- Net earnings: Also referred to as net income, you get it by subtracting your total costs (including interest and taxes) from your total income. If this number is positive, your business was profitable during a specific period of time. If it’s negative, you experienced a financial loss since you spent more money on expenses than you brought in through revenue and other income.
What Goes on the Balance Sheet?
While your income statement shows you your total profit or loss for a given period, your company’s balance sheet outlines your financial position on a specific day by comparing what you own (your assets) to what you owe others (liabilities).
Here's a template you can use for your business. (Just click on "Make a copy" to get started.)
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There are three sections on the balance sheet: assets, liabilities, and equity. Here’s what’s included in each area.
Assets
Assets refer to anything your business owns that has monetary value, such as cash, inventory, and even patents and copyrights.
On the balance sheet, you’ll usually find assets divided into separate categories, including:
- Current assets: Items you own that will be sold or converted into cash within 12 months or less. For instance, cash, cash equivalents, inventory, and accounts receivable.
- Fixed assets: Assets that you don't plan on converting into cash within the next 12 months, like real estate and equipment.
- Other (and intangible) assets: Assets that don’t have a physical form and can’t be converted into cash easily. Examples include patents, copyrights, and intellectual property. If you have intangible assets, you may want to consult a finance professional to help you find the calculated intangible value (CIV) to put on your balance sheet. Here you can also include accumulated amortization on intangible assets.
Liabilities
The liabilities section represents the money you owe others, such as your vendors, suppliers, and lenders.
Similar to the assets section, your liabilities section will be separated into a couple of different sections, including:
- Current liabilities: Short-term loans and lines of credit you expect to pay off within 12 months, such as credit cards.
- Long-term debt: Loan amounts that will take more than 12 months to pay off, like business loans. (Note: You'll include the current portion of this debt in your current liabilities.) This is also referred to as long-term liabilities.
Equity
The final section on the balance sheet contains money held as equity in the business. Equity is the amount left over for the owner (or shareholders) if all assets were liquidated and all debts were paid off. In other words, equity is total assets minus total liabilities.
Types of equity include:
- Invested capital: Investment from shareholders, which companies get by selling stocks or issuing bonds
- Retained earnings: Total net income (i.e., profit) from prior years that hasn’t been distributed to shareholders
- Net income: Total net income (i.e., profit) from current year
If you’re the sole owner of a business, this is the owner’s equity.
Key Differences Between Income Statement and Balance Sheet
Ultimately, the income statement and the balance sheet provide different methods for assessing your company’s financials.
Here are the key differences between these two financial reports:
Timing
When you look at an income statement, you’re looking at your financial data over a period of time, such as a month, quarter, or year. In contrast, a balance sheet only looks at your financial position at a single point in time, such as year-end.
Metrics Reported
Your income statement and balance sheet have different financial metrics on them. Your income statement includes your revenue and expenses, while your balance sheet shows your company's assets, liabilities and equity.
You usually create the income statement first since it provides the information you need for the balance sheet. In particular, your current net income or net loss goes in the owner’s (or shareholder’s) equity section of the balance sheet.
Financial Performance
Since the income statement looks at your finances over time, you can use it for analyzing financial performance.
You can use the income statement to answer questions like:
- Was my business profitable last month?
- How profitable was the company this year?
The balance sheet doesn’t tell you about your company’s performance over time. Instead, it looks at everything you own and owe and answers questions like:
- Can I pay my bills?
- How much is left over for owners and shareholders after all debts are paid?
- How much can I re-invest into the company?
- Do I currently have enough assets to take on a loan?
While it’s crucial to answer these questions for yourself, you’re not the only one asking them.
Investors will want to know about a company's profitability and assets vs. liabilities before giving money to you. Banks will want your balance sheet to see if you have enough assets to take on new debt.
What an Income Statement and Balance Sheet Have in Common
The income statement and balance sheet do share some commonalities. Let’s take a look at what the two have in common.
- They make up two of the three major financial statements, along with the cash flow statement.
- They’re helpful to business owners who want to assess financial performance and health.
- Both may be used by investors or lenders when deciding whether to give your business money.
Is the Income Statement or Balance Sheet More Important?
Both the income statement and balance sheet are important. An income statement tells you how profitable you are, and a balance sheet tells you how much money (and other assets) you have to pay your bills and debt and to provide a return on investment to owners and shareholders.
It can take a while to turn a profit initially, and you may even need to take out loans to get your new business off the ground. But your ultimate goal is to generate a profit and have more assets than liabilities.
And now that you understand how both of these financial statements can tell you if your business is on track–all that’s left to do? Start crunching those numbers!
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