The Difference Between a Balance Sheet and an Income Statement (video)
Even if you have an accountant, every business owner should know the difference between a balance sheet and an income statement—that’s called smart money management. Actually, a business owner not only needs to understand the purpose of a balance sheet and small business income statement but also all the critical indicators of their business’s finances. Reviewing these metrics every month is a great habit to form when you building your business. There’s no better feeling than keeping score on how your business is doing.
Before diving into the difference between a balance sheet and an income statement, let’s take a look at each one.
Difference Between a Balance Sheet and an Income Statement
A balance sheet is one part of a business’s financial documents that offer a good picture of your company’s overall fiscal health. The differences between a balance sheet and an income statement are many, but in general, a balance sheet has three components:
- Assets. These are the company’s financial resources and include current assets, fixed assets, and other assets. Current assets would be cash, accounts receivables, inventory, and assets that can be converted to cash quickly, called liquid assets. Current assets are essential to companies because they are available to fund daily business operations and operating expenses. Fixed assets are long-term assets your company retains for more than a year, such as real estate, buildings, equipment, and automobiles. Other assets may include intangible assets such as patents and trademarks.
- Liabilities. Liabilities include what the business owes currently and what it will owe in the future. They can be broken into two categories: current liabilities and long-term liabilities. Current liabilities are things that need to be paid within a year, such as accounts payable, payroll, taxes, and credit card bills. Long-term liabilities take longer than a year to be paid, such as a mortgage, rent (because it’s ongoing), business loans, and pension obligations.
- Owners’ or shareholders’ equity. The third section of the balance sheet combines the business’s assets and liabilities to calculate the company’s equity. Hopefully, the figure is a positive one since that shows the business is doing well and looks solid to potential investors. This is a crucial difference between a balance sheet and an income statement—more on that later.
One important note: It is unnecessary to include a business line of credit on your balance sheet unless you draw from it. Once you use your line of credit, the amount gets listed as a liability until you pay it back.
Why do you need to understand and review your company’s balance sheet? Because it shows your company’s value at a specific period in time, offers insight into your business’s future, and serves as an early warning system to possible problems in your business. A company with a bright future should be growing equity by increasing assets and decreasing liabilities. Although there may be components of a balance sheet that could sound similar to a profit-and-loss statement (income statement), there is a distinct difference between a balance sheet and an income statement.
Difference Between an Income Statement and a Balance Sheet
A small business income statement shows the total revenues and expenses for a specific period of time, such as weekly, monthly, or annually. Also called a profit-and-loss statement, the income statement shows your company’s net profit. The most significant difference between a balance sheet and an income statement is that a balance sheet doesn’t indicate performance. Yes, it shows what the business owes and what it owns, but the income statement shows your performance.
While the balance sheet lists the company’s assets and liabilities (short-term and long-term), an income statement includes the business’s sales (revenue), gross profits, expenses, cost of goods sold, net earnings, and earnings before taxes. One of the differences between a balance sheet and an income statement is that when a business owner needs a detailed analysis of the business (whether or not it’s for a lender), the income statement is the document they turn to since it provides the information they need.
Business owners typically compare income statements from the same time period year-to-year to show performance dips and spikes and to help them plan for everything from inventory needs to scheduling staff. For example, if net profits tend to increase in the first few months of every calendar year and then fall off dramatically by summer, a business owner can strategically plan to cut expenses before May to make it through the summer months unscathed.
You can see the difference between a balance sheet and an income statement in the components of the income statement:
- Operating revenue: Money the business earns from supplying a service or selling products.
- Nonoperating revenue: Revenue earned through other business activities, such as royalties or rent.
- Gains: or “other income.” Money from selling real estate or equipment.
- Expenditures: Money spent on goods or services to operate the business. Expenditures are not expenses. They are things you pay for at the time of purchase, not over a period of time.
- Cost of goods sold (COGS): The costs related to selling your products, such as materials and labor.
- Operating expenses: Costs not associated with the core business, such as rent, office supplies, and utilities.
- Depreciation: Expenses paid for over a period of time.
- Wages/Salaries: Money paid to the owner and employees.
- Earnings before taxes: The business’s income before taxes.
- Gross profit: The gross profit is calculated by subtracting COGS from revenue.
- Net profit: The amount left over after subtracting all expenses from gross profits.
Every business must use a consistent accounting method to create an accurate income statement. The two standard accounting methods are the cash method and the accrual method. The difference between cash and accrual accounting is in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned and expenses when they’re billed (but not paid).
The Cash Flow Statement Versus a Balance Sheet and Income Statement
The final piece to a small business owner’s financial statement is the cash flow statement, which reflects the money that moves in and out of your business. A small business cash flow management statement shows where the money came from and where it went at any specified period of time. It also helps calculate your debt-to-income ratio, which is critical if your business ever needs to apply for additional funding. Along with your balance sheet and income statement, the cash flow statement is an integral part of your company’s financial reports which can also help with budgeting and planning.
Knowing the difference between a balance sheet and an income statement while keeping your eye on your business’s cash flow is the fundamental ingredient to maintaining solid finances and promoting business growth. However, even the healthiest businesses need an emergency infusion of cash now and then. Having a cash backup plan in place means your business can afford to replace a crucial broken piece of equipment or expand offices to accommodate new business.
Financial Solutions, a direct lender, has a great unsecured business line of credit that is specifically designed for small businesses like you. It costs nothing until used and is intended to be a great cash backup plan for emergencies or new opportunities. Apply today with the simple, no-obligation, 2-minute line of credit application here.