It has frequently been said that accounting is the “lifeblood” of the modern business world. With good accounting practices in place, a business will be able to recognize its financial position, assure it remains in good standing with all relevant parties, and also is in a position to make better financial decisions. Inevitably, generating and using financial statements becomes one of the most important components of the accounting process.
For both small and large businesses alike, financial reports serve several important purposes. These reports will be regularly utilized to evaluate the state of the company and chart the best path forward. They will also be viewed by several relevant parties, including tax authorities and regulators, potential investors, and even competitors. Because financial reports are used both internally and externally, they are closely regulated by FINRA, the SEC, and other relevant authorities.
There are many different types of financial statements. The five most common types of financial statements are the balance sheet, income statement, statement of cash flow, statement of changes in equity, and statement of financial position. However, the balance sheet and the income statement are often recognized as the most important, as will be discussed below.
In this article, we will compare the balance sheet vs income statement and discuss why both these financial statements are so important. We will also discuss how decision-makers at various levels use this information to help pursue their financial goals.
What is a Balance Sheet?
A balance sheet is a “snapshot” that reports what a business owes and owns at a specific point in time. A balance sheet represents information relevant on a specific date, such as December 31, 2020. A balance sheet reports three categories: assets, liabilities, and shareholder’s equity.
With a balance sheet, it is crucial that the value of the asset column equals the sum of the liabilities and shareholder’s equity column. This means the balance sheet is sound, at least in an accounting sense. The assets column represents everything the business currently owns, which can include physical property, cash, equipment, trademarks, and many other things. The liabilities column represents everything the company owes, which can include both long-term and short-term debt.
The shareholder’s equity column represents everything else that is left over. A company’s “balance sheet value” is determined by how much greater the assets column is than the liabilities column. This simple equation is often referred to as the company’s “worth.” Balance sheets can change on a daily basis and for larger businesses, they almost always will.
What is an Income Statement?
An income statement is a financial statement that communicates how much income a company was able to generate over a specific period of time. The statement categorizes each of the company’s revenues within the period and each of the company’s expenses, with the difference between these two numbers representing profit (or loss).
Typically, an income statement will represent events taking place over the course of the year, but this can vary by circumstance. An income statement might alternatively be titled “Revenues and Expenses from January 1, 2020, to December 31, 2020”, or something along these lines. Businesses might also use quarterly, monthly, or even weekly income statements to examine their financial performance more closely.
By looking at an income statement, you can easily tell whether a business was profitable or not profitable within a specific period. If total revenue is greater than total expenses, this means the business was profitable. If total revenue is less than total expenses, this means the business was not profitable. Some businesses can afford (or are even designed) to not generate a profit for a while, but regardless, it is important for all business owners to know exactly where they stand.
Balance Sheet vs Income Statement
Clearly, both the balance sheet and the income statement—along with other financial statements, such as the statement of cash flow—can be very useful. However, to know whether you should use a balance sheet vs income statement, it is important to identify the structural differences between the two.
Timing and Structure: while the balance sheet clearly identifies what a business owns and owes at a single point in time, the income statement illustrates a business’ revenues and expenses over a set period.
Doing vs Owning: a balance sheet shows what a business owns, but only the income statement actually illustrates how a business has been performing.
Typical Usage: the balance sheet will be used by a company to determine if it has the resources (such as cash) to satisfy all of its financial obligations. The income statement, on the other hand, is used to evaluate whether a business is profitable and determine which changes might need to be made.
Revenue Recognition: while on the balance sheet, “accounts receivable” can be considered to be an asset, an income statement will not recognize that revenue until it has actually been received.
Creditors: lending institutions and creditors will usually be more concerned with the balance sheet because a company’s assets can be used as leverage in the event that something goes wrong. However, it certainly helps to have an income statement that shows your business has been profitable.
Ultimately, there is no way around it: both these financial statements will be crucial for decision-makers at every level.
Balancing Your Books
For those who are wondering how to create a balance sheet or how to create an income statement, it is important to recognize that these two financial statements often work together. We will illustrate, with a few examples below:
A company decides to use cash to purchase a new computer. On the income statement, the cost of the computer will be added to the “expense” column, perhaps labeled as “equipment.” Within the assets column on the balance sheet, cash will be subtracted and then re-added as “equipment.”
A company sells 10 percent of its inventory. On the income statement, the value of this inventory will be added to the “revenue” column, thus increasing the company’s net profit. On the balance sheet, the value of the inventory will be subtracted from the “inventory” line on the asset side, then re-added as cash.
Whether you plan on managing your books on your own or plan on hiring an accountant, it is critical to understand how your income statements and balance sheet affect one another. Every time your business makes a financial transaction, it is possible that both your present balance sheet and future income statement can change.
To master these financial statements, you will need to learn how to determine what is revenue and what is an expense, and what is a liability, an asset, or shareholder’s equity. As long as you can account for all financial activity and keep balanced books via double-sided accounting, your business will be able to use these financial reports to your advantage.
Ultimately, there is a lot you can learn from your income statement and your balance sheet. The balance sheet offers a snapshot in time, illustrating all that your company currently owns (assets and equity) and owes (liabilities). The income statement, on the other hand, records your revenue and expenses (and, consequently, net profit) within a specific period of time. Use both financial statements to evaluate your current state of affairs and make strategic choices for the future.
Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.