What are the links between the statement of financial position elements and the statement of the income statement elements?

The balance sheet and income statement are both important documents to business owners everywhere. When a company has a strong income statement it will usually have a good balance sheet, but it is possible for one of them to be weak while the other is strong. You may now be asking yourself what makes this happen—what makes them different? In the balance sheet versus income statement fight, who wins?

We can see the difference in what exactly each one reports. The income statement gives your company a picture of what the business performance has been during a given period, while the balance sheet gives you a snapshot of the company’s assets and liabilities at a specific point in time. That is just one difference, so let’s see what else makes these fundamental reports different.

What is a Balance Sheet?

The balance sheet is a snapshot of what the company both owns and owes at a specific period in time. It’s used alongside other important financial documents such as the statement of cash flows or income statement to perform financial analysis. The purpose of a balance sheet is to show your company’s net worth at a given time and to give interested parties an insight into the company’s financial position. 

What Is Included in a Balance Sheet? 

The balance sheet is a financial statement comprised of assets, liabilities, and equity at the end of an accounting period. 

• Assets include cash, inventory, and property. These items are typically placed in order of liquidity, meaning the assets that can be most easily converted into cash are placed at the top of the list. 
• Liabilities are a company’s financial debts or obligations. They include things such as taxes, loans, wages, accounts payable, etc. 
• Equity is the amount of money originally invested in the company, as well as retained earnings minus any distributions made to owners.

The foundation of the balance sheet lies in the accounting equation where assets, on one side, equal equity plus liabilities, on the other. 

The formula is intuitive: a company has to pay for everything it owns (assets) by either taking out a loan (liability), taking it from an investor (issuing shareholders’ equity) or taking it from retained earnings.

For example, if a company takes out a 5 year, $6,000 loan from the bank not only will its liabilities increase by $6,000, but so will its assets. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders’ equity. 

$14,000 (Assets) = $6000 (Liabilities) + $8000 (Equity)<\>\r\n

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$14,000 (Assets) = $14000 ( Liabilities + Equity)<\>\r\n“, “_callout_content”: “field_5d66c8b4cf08c” }, “align”: “”, “mode”: “preview” } /–>

The company’s total assets need to equal total liabilities plus equity for the balance sheet to be considered “balanced.”

The balance sheet shows how a company puts its assets to work and how those assets are financed based on the liabilities section. Since banks and investors analyze a company’s balance sheet to see how a company is using its resources, it’s important to make sure you are updating them every month. 

What Is an Income Statement?

The income statement, often called a profit and loss statement, shows a company’s financial health over a specified time period. It also provides a company with valuable information about revenue, sales, and expenses. These statements are used to make important financial decisions. 

Both revenue and expenses are closely monitored since they are important in keeping costs under control while increasing revenue. For example, a company’s revenue could be growing, but if expenses are growing faster than revenue, then the company could lose profit.

Usually, investors and lenders pay close attention to the operating section of the income statement to indicate whether or not a company is generating a profit or loss for the period. Not only does it provide valuable information, but it also shows the efficiency of the company’s management and its performance compared to industry peers.

What’s Included in an Income Statement?

Income statements include revenue, costs of goods sold, and operating expenses, along with the resulting net income or loss for that period. 

An operating expense is an expense that a business regularly incurs such as payroll, rent, and non-capitalized equipment. A non-operating expense is unrelated to the main business operations such as depreciation or interest charges. Similarly, operating revenue is revenue generated from primary business activities while non-operating revenue is revenue not relating to core business activities. 

Balance Sheet vs Income Statement: The Key Differences

It is important to note all of the differences between the income and balance statements so that a company can know what to look for in each. 

• Timing: The balance sheet shows what a company owns (assets) and owes (liabilities) at a specific moment in time, while the income statement shows total revenues and expenses for a period of time. 
• Performance: The balance sheet doesn’t show performance—that’s what the income statement is for.
• Reporting: The balance sheet reports assets, liabilities, and equity, while the income statement reports revenue and expenses.
• Usage: The company uses the balance sheet to determine if the company has enough assets to meet financial obligations. The income statement is used to evaluate performance and to see if there are any financial issues that need correcting.
• Creditworthiness: Lenders use the balance sheet to see if they should extend any more credit, but they use the income statement to decide on whether or not the business is making enough profit to pay its liabilities. 

Do They Have Anything in Common?

Although the income statement and balance sheet have many differences, there are a couple of key things they have in common. Along with the cash flow statement, they make up three major financial statements. And even though they are used in different ways, they are both used by creditors and investors when deciding on whether or not to be involved with the company. 

While we can conclude that the income statement and balance sheet are used to evaluate different information, we can agree that both statements play important roles to banks and investors because they provide a good indication on the current and future financial health of a company.

Want to dig a little deeper to understand how to read each of these reports? Check out our blog post, A Complete Guide to Reading Financial Statements.

Even your books need a second opinion.

Learn about financial statements and reports including profit and loss, cash flow and balance sheets.

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Financial statements are historical. They show you how your business has been operating in areas such as profitability, cash flow, assets and liabilities.

There are 3 major financial statements to understand:

• profit and loss statement
• balance sheet
• cash flow statement.

These statements are important to help you:

• meet your regulatory requirements
• understand and manage the overall success of your business
• plan for future growth.

You should produce financial statements regularly and keep them up to date.

Profit and loss statements

A profit and loss statement, also known as an income statement, shows the profitability of your business over a specific period. It can cover any period of time, but is most commonly produced monthly, quarterly or annually.

A profit and loss statement is a useful tool for monitoring business activity.

• As a business owner, it highlights where your business is succeeding and where it may be struggling.
• For investors, it shows the financial health of a business before they decide to invest, or to see what return they are getting on an existing investment.

Contents of a profit and loss statement

Your profit and loss statement will generally be split into 2 sections:

• Revenue—all income from your
  • primary business activities (e.g. sales of products and services)
  • secondary activities (e.g. bank interest)
  • any other financial gains (e.g. profit on sale of assets).
• Expenses—what you're spending on primary activities (e.g. material and labour costs), secondary activities and any other losses during the period (e.g. losses on disposal of assets).

Revenue

The most important part of the revenue section of your profit and loss statement is total sales. Secondary revenue and other income can be unpredictable, so you should focus on your primary sales revenue to grow your business.

Secondary sources of revenue can include:

• bank interest
• financial gains (e.g. profit on sales of property or assets).

Note how much sales have risen or fallen since your previous profit and loss statement.

Breaking sales figures down into individual products or product lines will help you see which products are performing well and which products need attention.

Always look to maintain or increase revenues over time. A pattern of falling revenue may indicate that your business is in trouble.

Expenses

The 2 main sets of figures in the expenses section of a profit and loss statement are:

• cost of goods sold (the cost of direct labour and any raw materials used to produce your goods or services)
• operating expenses (the cost of indirect labour and any other costs not directly linked to producing goods or services).

Aim to minimise your business costs wherever possible. Rising material costs could mean you need to find a different supplier, or find more efficient production methods. Some increases are inevitable, with inflation likely to cause costs to increase across a market over a period of time.

Operating expenses can be harder to reduce. For example, if your rent rises it may not be practical to move to alternative premises, or moving may be more expensive than paying the increased rent amount.

Check your profit and loss statement for any sudden or unexpected spikes in costs, rather than gradual increases over time (due to factors such as inflation and annual employee pay rises).

How to calculate profit

Use your profit and loss statement to extract important figures to explain your business's profitability:

• Gross profit = Total revenue - Cost of goods sold
  This is the difference between total sales and the cost of producing the goods or services you sell. This is an indicator of overall production efficiency and a key figure for setting prices and sales targets.
• Gross profit margin = (Gross profit ÷ Total revenue) x 100
  This shows what proportion of gross profit you keep from each dollar of revenue generated (e.g. 20% gross profit margin means you keep a gross profit of $0.20 for every $1.00 of revenue generated).
• Operating profit = Gross profit - Operating expenses
  This shows profit generated from core operations. It does not include expenses from interest or taxes (often called earnings before interest and tax, or EBIT).
• Net profit = Total revenue - (Costs of goods sold + Operating expenses)
  This is also known as the 'bottom line'—net profit is the total amount earned (or lost) after paying all expenses.

Balance sheets

A balance sheet (also known as a statement of financial position) is a summary of all your business assets (what your business owns) and liabilities (what your business owes). At any point in time, it shows you how much money you would have left over if you sold all your assets and paid off all your debts. This is also known as ‘owner's equity’.

There are 3 sections in a balance sheet, represented by the following:

Formula: Owner's equity = Assets - Liabilities

It is called a balance sheet because, at any given moment, each side of this equation must 'balance' out.

Assets

Current assets are assets your business plans to keep for a short period of time, usually less than 12 months. They include:

• cash at bank
• short-term investments
• stock
• trade debtors (people who owe the business money)
• petty cash.

Fixed assets are assets your business plans to keep for a longer period, usually more than 12 months. They are also called non-current or capital assets. They include:

• building improvements
• plant and equipment
• motor vehicles
• office equipment.

Intangible assets are assets you can't touch and can include:

• intellectual property—knowledge, information or processes that set your business apart from others
• trademarks and patents—formally registered concepts that bring value to your business
• goodwill—the amount you pay for the reputation and performance of a business if you buy one, sometimes called 'business value'.

Learn more about how to value business assets.

Liabilities

Current liabilities are usually things you will pay for during the next 12 months. They may include:

• overdrafts that must be settled, or overdraft charges
• short-term loans
• creditors, including trade creditors
• taxes.

Non-current liabilities are things that you will not pay for, or pay off, within a year of your balance sheet date. They include:

• long-term loans
• secured bills
• director's loans (to the business)
• residual value on leases or loans due in more than 12 months.

Owner's equity, also called shareholders' equity in companies, is the remaining portion of a business that belongs to the owner(s) after deducting total liabilities from total assets.

Make sure you consider depreciation when interpreting your balance sheet. Every time your business uses a fixed asset—such as office equipment or a vehicle—some of its value is lost.

Australian tax law requires you to spread the cost of assets over the years in which you use them (depreciation).

A cash flow statement shows how much cash is moving in and out of your business over a period of time. This reflects the 'liquidity' of your business.

Having enough cash available to pay your debts and buy materials and assets is an important part of business planning. A cash flow statement will quickly tell you if you are likely to have any issues in this area.

Cash flowing in is most often the money you get from sales, but it may also be from:

• debt repayments
• selling unnecessary assets
• rebates
• grants.

Your outgoing cash includes expenses such as:

• payments to suppliers
• wages and super
• bills
• maintenance
• other business expenses.

Read more about managing cash flow and cash-flow invoices and payments.

There are normally 3 sections in a cash flow statement, each relating to a different area of your business.

This section contains the main cash-generating activities of your business. This is generally any money earned or spent in the day-to-day running of your business.

The largest figure in this section should be the net income generated by sales of the goods or services you produce.

Accounts receivable (money owed to you) and accounts payable (money you owe) will also appear in this section. If accounts receivable are increasing at a faster rate than income from sales, you may have a problem managing your debtors.

This section measures the flow of cash between your business and its owners and creditors.

Cash income in this section can include:

• any funds borrowed
• public issues of shares or bonds.

Cash expenditure in this section can include:

• loan repayments
• dividends paid out
• re-purchased shares or bonds.

Investing activities listed in this section generally include purchases or sales of long-term assets, such as property, plant and equipment. Include the sale or purchase of investment securities here.

Your cash flow statement may include a few or many items, depending on the size and complexity of your business. The most important figure is your net cash flow, found at the bottom of the statement.

Compare this figure with the net cash flow from your previous statement. If your cash reserves:

• increase, this usually indicates your business is healthy and heading in the right direction
• stay roughly the same, there may only be problems if your reserves are low
• decrease, you may find it difficult to pay your debts and need to rely more heavily on credit. Take immediate action to resolve what is causing your cash shortfalls.

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• Last reviewed: 20 Dec 2021
• Last updated: 20 Dec 2021