The profit and loss statement and the balance sheet are two of the three financial statements that companies issue regularly. Financial statements provide an ongoing record of a company's financial condition and are used by creditors, market analysts, and investors to evaluate a company's financial soundness and growth potential. The third financial statement is called the cash-flow statement.
Although the balance sheet and the profit and loss statement (P&L) contain some of the same financial information including revenues, expenses, and profits, there are important differences between the two of them.
A balance sheet reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.
The balance sheet shows a company's resources or assets while also showing how those assets are financed whether through debt as shown in under liabilities or through issuing equity as shown in shareholder's equity. The balance sheet provides investors and creditors alike with a snapshot as to how effectively a company's management is using their resources. Below are a few examples of the items on a typical balance sheet.
- Cash and cash equivalents: the most liquid assets, which may include Treasury bills, short-term certificates of deposit and cash
- Marketable securities: equity and debt securities for which there is a liquid market
- Accounts receivable: money owed to the company by customers
- Inventory: goods available for sale
- Shareholders' equity is equal to a firm's total assets minus its total liabilities and is one of the most common financial metrics employed by analysts to determine the financial health of a company. Shareholders' equity represents the net value of a company, or the amount that would be returned to shareholders if all the company's assets were liquidated and all its debts repaid.
- Retained earnings is recorded under shareholder's equity and refers to the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to pay debt.
Trial balance and the Balance Sheet
It's important to note that the trial balance is different from the balance sheet in that it's an internal report that stays in the accounting department. The balance sheet, on the other hand, is a financial statement that's distributed to other departments, investors, and lenders.
The trial balance provides financial information at the account level such as general ledger accounts and, is therefore, more granular. Eventually, the information in the trial balance is used to prepare the financial statements for the period.
In contrast, the balance sheet aggregates multiple accounts, summing up the amount of assets, liabilities and shareholders' equity in the accounting records at a specific time. The balance sheet includes outstanding expenses, accrued income, and the value of closing stock, whereas the trial balance does not. Also, the balance sheet must adhere to a standard format as described in an accounting framework, such as the International Financial Reporting Standards (IFRS) or the generally accepted accounting principles (GAAP).
A profit and loss statement, often referred to as the income statement, is a financial statement that summarizes the revenues, costs, and expenses incurred during a specific period of time, usually a fiscal quarter or year. These records provide information about a company's ability – or lack thereof – to generate profit by increasing revenue, reducing costs, or both. The P&L statement is also referred to as "statement of profit and loss," "statement of operations," "statement of financial results," and "income and expense statement."
The P&L or income statement provides the top line and bottom line for a company. The statement begins with an entry for revenue, known as the "top line," and subtracts the costs of doing business, including cost of goods sold, operating expenses, tax expense, interest expense and any other expenses (sometimes referred to as extraordinary expenses or one-time expenses). The difference, known as the bottom line, is net income, also referred to as profit or earnings.
The P&L statement reveals the company's realized profits or losses for the specified period of time by comparing total revenues to the company's total costs and expenses. Over time, it can show a company's ability to increase its profit, either by reducing costs and expenses or by increasing its sales. Companies publish income statements annually, at the end of the company's fiscal year, and may also publish them on a quarterly basis. Accountants, analysts, and investors study a P&L statement carefully, scrutinizing cash flow and debt financing capabilities.
From an accounting standpoint, revenues and expenses are listed on the P&L statement when they are incurred, not when the money flows in or out. One beneficial aspect of the P&L statement, in particular, is it uses operating and non-operating revenues and expenses, as defined by the Internal Revenue Service (IRS) and generally accepted accounting principles (GAAP).
The Differences Between the P&L Statement and Balance Sheet
The Role of Time
One of the major differences between the profit and loss statement and the balance sheet involves their respective treatments of time. The balance sheet summarizes the financial position of a company for one specific point in time. The P&L statement shows revenues and expenses during a set period of time. The length of the period of time covered in the P&L statement may vary, but common intervals include quarterly (three months) and annual statements.
Purpose of Each Statement
Each document is built for a slightly different purpose.
The P&L statement answers a very specific question: Is the company profitable? Whereas accountants use the P&L statement to help gauge the accuracy of financial transactions and investors use the P&L statement to judge a company's health, the company itself can review its own statement for productive purposes. Closely monitoring financial statements highlights where revenue is strong and where expenses are incurred efficiently, and the opposite is true as well. For example, a company might notice increasing sales but decreasing profits and search for new solutions to reduce costs of operation.
Balance sheets are built more broadly, revealing what the company owns and owes, as well as any long-term investments. Unlike an income statement, the full value of long-term investments or debts appear on the balance sheet. The name "balance sheet" is derived from the way that the three major accounts eventually balance out and equal each other; all assets are listed in one section, and their sum must equal the sum of all liabilities and the shareholders' equity.
Profit Versus Total Value
The P&L statement shows net income or whether or not a company is in the red or black. The balance sheet shows how much a company is actually worth or its total value. Though both of these are a little oversimplified, this is often how the P&L statement and the balance sheet tend to be interpreted by investors and lenders.
It's important to note that investors should be careful to not confuse earnings/profits with cash flow. It's possible for a firm to operate profitably without generating cash flow or to generate cash flow without producing profits.
How the Statements Are Calculated
The income statement requires accountants to add up the company's revenue on one portion and add up all of its expenses on another. The total amount of expenses are subtracted from the total revenue, resulting in a profit or a loss. The balance sheet has a few different calculations that are all performed as representations of one basic formula: assets equal liabilities plus owner's equity.
The Bottom Line
When used together along with other financial documents, the balance sheet and P&L statement can be utilized to assess the operational efficiency, year-to-year consistency, and organizational direction of a company. For this reason, the numbers reported in each document are scrutinized by investors and by the company's executives. While the presentation of these statements varies slightly from industry to industry, large discrepancies between the yearly treatment of either document is often considered a red flag.
A firm's ability, or lack thereof, to generate earnings consistently over time is a major driver of stock prices and bond valuations. For this reason, every investor should be curious about all of the financial statements, including the income statement and the balance sheet, of any company of interest. Once reviewed as a group, these financial statements should then be compared with other companies in the industry to obtain performance benchmarks and to understand any potential market-wide trends.