Some people study for years to end up in business. For others, the path is not so predetermined. They one day stumble into business and find themself unaware of a lot of things. The most annoying of these things probably come in the form of accounting concepts. Two things which to the initiated are regarded as elementary but cause havoc to those not quite familiar with them are the Income statement and the balance sheet. Let’s dissect these two key statements to understand their goals, contents and how to interpret the information in them.
Let’s start with the income statement. The purpose of the income statement is to present information relating to the performance of a business. It takes information relating to income received and expenditure incurred in the process of the ordinary functions of the business. So it will summarise information from sales, purchases, salaries, administrative expenses and other expenses to arrive at an accounting measure of how the business has performed. In fact, it is easier to understand the purposes of the income statement if we look at the other names it goes in different accounting conventions such as Profit and Loss Statement or Statement of Financial Performance.
When looking at the income statement the key thing is the bottom line, that is, the profit. This may be expressed as net profit, net income, comprehensive income, Earnings or Earnings Before Interest and Tax (EBIT). Income statements also look at the performance over a period. So the statement can be for a month, quarter, half-year or full year.
The Balance Sheet has a completely different focus from the income statement, of course. While the income statement looks at the performance of a business over a period the balance sheet takes a snapshot of a business at a given moment in time to ascertain the balances of all items the business owns (assets) or owes (liabilities) to arrive at a fair value for the business and therefore the value to the owners of the business. The balance has also gone by different names under various accounting conventions including the extremely descriptive Statement of Assets and Liabilities and Statement of Financial Position.
The key output of a balance sheet is the owner’s equity. This can be expressed as shareholder’s equity in a company set up. That may be the most important outcome but it also contains information on Current Assets (to be used within 12 months), Non-Current Assets (expected to last longer than 12 months and liabilities with the same distinctions as the assets of Current and Non-Current.
Financial performance vs Financial position
So the difference between the two statements is a matter of perspective. The income statement looks at how well the business is doing, in terms of income versus expenditure. The Balance sheet looks at the position of the business through balances of assets and liabilities. It helps to determine the liquidity and solvency of the business, at least technically. The information in the two statements is useful to different user groups though there are intersections. The income statement has vital information for management, tax authorities, employees and investors. The information in the Balance Sheet is useful to management, creditors (lenders) and investors.
While the two statements are evidently far apart they are not unconnected as the discussion we have had so far may lead you to believe. The income statement’s main output is either profit or loss. Profit indicates an increase in the value of the business while a loss would result in an erosion in the value of the business. Profit (or loss) is recognised in the Balance sheet together with the owner’s equity which it impacts.
In the course of this discussion, I’ve chosen to use very plain language to make the discussion about these two statements inclusive to as wide a user pool as possible. To make the best sense of the discussion having a sample of a pair of the statements (same company and same date is best) will help you understand the statements better than just reading along.