The balance sheet and income statement are two of three primary financial statements every business should run and review monthly. One question I often get asked by small business owners is, “What is the difference between a balance and an income statement?” Understanding the difference between the reports is vital as they show differing information about the business, which you, as a business owner, need to be aware of as you make daily operational decisions. This blog will look briefly at four differences between the reports.
- Net Equity versus Net Profit (Loss)
The balance sheet reports a business’s net equity (or value). Third parties use this information to determine the value investing in the business would bring. The income statement reports the financial performance of a business, which is determined by looking at the business’s net profit (or loss). Third parties also use this information to analyze if the business can repay borrowed funds.
- What Items Are On Which Report
The income statement houses the expenses and income of the business. Expenses are how much a business has spent in a given period, and income is how much the business has earned in a given period. The net of expenses and income is a business’s net profit or loss. The balance sheet houses the items owned by the business, called assets, and the items the business owes third parties, called liabilities. The assets represent all the items the business owns, while liabilities reflect all the items the business owes a third party. The net of the assets and liabilities is the business’ net equity (or value).
- The Timeframe Covered By the Report
The balance sheet is an ongoing report; the data it shows does not end at the end of the fiscal year. For example, if on the last day of the fiscal year, a business owns $6,000 in stock, on the first day of the new year, the business will still own $6,000 in stock. The close of a year does not end the business’ ownership.
However, an income statement is a limited report as its data does not carry over into the following year. For example, if the business shows $7,000 in rent expense on the last day of the year, then on day 1 of the new fiscal year, it should show $0 in rent expense, not $7,000. On day 1 of a new fiscal year, every account on the income statement should have a $0 beginning balance.
- The Importance of The Report for the Business Owner
Both the income statement and the balance sheet provide valuable information for the business owner. The balance sheet’s liabilities section shows various future expenses the business will need to pay, and the assets section shows different sources that can be used to pay down the liabilities (like cash) or develop the business further (like inventory). The net equity, assets less liabilities, informs the owner how valuable her business is. The higher the net equity, the more valuable the business is; the lower the net equity, the less valuable the business is. The income statement shows how profitable the business is performing. The more income over expenses, the more profitable a business is performing. The less income over expenses, the less profitable a business is performing. Equipped with this information, the owner can make sound operational decisions, for example, hiring more staff, taking out a business loan, or increasing income channels.
Understanding the difference between a balance sheet and an income statement is a necessity for every business owner in order for her to know the value of the business and what business developments she can make based on the value and the performance of the business.