The balance sheet and the profit and loss (P&L) statement are two of the three financial statements companies issue regularly. Such 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.
- A balance sheet reports a company's assets, liabilities and shareholder equity at a specific point in time.
- A balance sheet provides both investors and creditors with a snapshot as to how effectively a company's management uses its resources.
- A profit and loss (P&L) statement summarizes the revenues, costs and expenses incurred during a specific period of time.
- A P&L statement provides information about whether a company can generate profit by increasing revenue, reducing costs, or both.
A balance sheet reports a company's assets, liabilities and shareholder equity at a specific point in time. It provides a basis for computing rates of return and evaluating the company's capital structure. This financial statement 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, and it also shows how those assets are financed—whether through debt under liabilities or by issuing equity as shown in shareholder equity. The balance sheet provides both investors and creditors with a snapshot of how effectively a company's management uses its resources. Just like the other financial statements, the balance sheet is used to conduct financial analysis and to calculate financial ratios. Below are a few examples of the items on a typical balance sheet.
- Cash and Cash Equivalents. These are the most liquid assets, which may include Treasury bills (T-bills), short-term certificates of deposit (CDs) and cash.
- Marketable Securities. This category includes equity and debt securities for which there is a liquid market.
- Receivables. Also known as accounts receivable, this represents money owed to the company by customers.
- Inventory. This area covers all the goods available for sale.
- Debt. This includes the current portion of long-term debt and bank indebtedness.
- Overhead. This accounts for such financial obligations as rent, tax, and utilities.
- Payables. This includes both wages and dividends owed.
Shareholder 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. Shareholder equity represents the net value of a company, meaning the amount that would be returned to shareholders if all the company’s assets were liquidated and all its debts repaid.
Retained earnings are recorded under shareholder equity and refer to the percentage of net earnings not paid out as dividends but retained by the company either to be reinvested in its core business or to pay the debt.
Trial Balance vs. the Balance Sheet
It's important to note that the trial balance is different from the balance sheet. This is an internal report that stays in the accounting department. The balance sheet, on the other hand, is a financial statement 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 number of assets, liabilities and shareholder equity in the accounting records at a specific time. The balance sheet includes outstanding expenses, accrued income, and the value of the closing stock, whereas the trial balance does not. In addition, 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).
Profit and Loss (P&L) Statement
A P&L 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 year or quarter. 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's many monikers include the "statement of profit and loss," the "statement of operations," the "statement of financial results," and the "income and expense statement."
Top Line and Bottom Line
The P&L statement provides the top and bottom line for a company. It begins with an entry for revenue, known as the top line, and subtracts the costs of doing business, including the cost of goods sold, operating expenses, tax expenses, interest expenses, and any other expenses sometimes referred to as "extraordinary" or "one-time" expenses. The difference, known as the bottom line, is net income, also referred to as profit or earnings.
Realized Profits and Loss
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 increasing sales. Companies publish P&L 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.
Revenues and Expenses
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 that it uses operating and nonoperating revenues and expenses, as defined by the Internal Revenue Service (IRS) and GAAP.
A balance sheet considers a specific point in time, while a P&L statement is concerned with a set period of time.
Balance Sheet vs. P&L Statement
Although the balance sheet and the P&L statement contain some of the same financial information—including revenues, expenses and profits—there are important differences between them. Here's the main one: The balance sheet reports the assets, liabilities and shareholder equity at a specific point in time, while a P&L statement summarizes a company's revenues, costs, and expenses during a specific period of time.
Purpose of Each Statement
Each document is built for a slightly different purpose. 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 appears 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 shareholder equity.
The P&L statement answers a very specific question: Is the company profitable? While 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.
Profit vs. Total Value
The P&L statement shows net income, meaning whether or not a company is in the red or black. The balance sheet shows how much a company is actually worth, meaning 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 P&L 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 loss. The balance sheet has a few different calculations that are all performed as representations of one basic formula:
Assets = Liabilities + Owner’s Equity
The Bottom Line
When used together along with other financial documents, the balance sheet and P&L statement can be used 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 the company's executives. While the presentation of these statements varies slightly from industry to industry, large discrepancies between the annual treatment of either document are often considered a red flag.
A firm's ability (or inability) 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 P&L statement and the balance sheet—of any company of interest. Once reviewed as a group, these financial statements should then be compared with those of other companies in the industry to obtain performance benchmarks and understand any potential market-wide trends.