We often see prospective clients paying special attention to the profit and loss statement (P&L), but ignoring the balance sheet. That’s a mistake, as our outsourced CFO services would suggest both are important. Let’s drill into their difference between the balance sheet and the P&L with this cheat sheet:
What’s covered in this blog:
- What is a profit and loss statement?
- What is a balance sheet?
- [Infographic] A Cheat Sheet: The balance sheet vs. P&L
- Examples of the difference between the balance sheet and the profit and loss statement.
The Profit and Loss Statement
A P&L statement reports on:
- Cost of Goods Sold
The P&L depicts a period of time summarizing operations. It is also referred to as the income statement.
Benefit: The P&L is useful for review of profit or loss over a certain interval of time (e.g. monthly, quarterly, annually). As a stand-alone report it only tells part of the story, but when compared to a budget it gives you a valuable comparison. For instance, the P&L can show the results or trends of one period to another (e.g., 2019 versus 2018 or actual versus budgeted).
Fun fact: the phrase, “the bottom line,” comes from the profit and loss statement as the bottom line records the net income, or profits.
When you examine the P&L example above, it looks pretty good, showing a 10% increase in net operating income (NOI). Now let’s compare the P&L to budget to really see what’s going on with this business.
Once you compare the P&L to budget, you see this business spent more on product than they had budgeted for, then cut personnel just to show a profit. This is the exact opposite of positioning your business to scale. Without comparing the P&L to budget you miss an integral part of the puzzle.
The Balance Sheet
The balance sheet reports on:
- Assets (accounts receivable, cash, inventory, property)
- Liabilities (rent, loans & long-term debt, taxes, wages)
The balance sheet depicts a snapshot in time.
Benefit: The balance sheet is good for comparisons and understanding company value. It is often required by lenders to obtain a loan or when you wish to apply for a business line of credit. The balance sheet report provides company health ratios like the acid test or debt-to-equity ratio and tells an important story about your financials. More relevant than the compliance need, these metrics help identify trends so you can adjust operations as needed to “balance” your risk and return. Your balance sheet shows how effectively your business is turning its profits into cash. If you aren’t regularly reviewing your balance sheet our outsourced accounting services may be the perfect solution!
Two reports, one bucket.
The P&L is the report to which most business owners default; however, if they wish to see their entire financial picture, the balance sheet is where they should be looking.
Think of the balance sheet as a bucket and the P&L as the flow of the water. The water coming from the faucet is the revenue that fills up the bucket. A hole in the bottom of the bucket is the expenses that drain out.
In the bucket analogy, the water in the bucket at any given time is the cumulative profit that the business has made so far (i.e. the equity). Your equity is the excess of assets over liabilities. Your goal should be to fill up your bucket as much as possible. For more help with your financial reporting check out our outsourced controller services.
Assets – Liabilities = Equity.
Still not clear on what the difference between the P&L and your balance sheet is? Here are a few examples:
The difference between the balance sheet and the profit and loss statement.
Example 1: Holding onto a Big Accounts Receivable Balance
If your company has a huge accounts receivable (AR) balance, on paper you could be making money, but in reality you don’t actually have the cash yet.
The P&L shows revenue from those sales, but does not reflect when you actually receive payment for those sales. Your balance sheet will highlight outstanding AR (i.e., you are waiting on more water yet to be added to the bucket).
Example 2: Manufacturing Companies with Numerous Fixed Assets
Companies that require a large quantity of equipment, like manufacturing companies, may have to spend a significant amount of money upfront on fixed assets. The fixed assets are taking up a lot of cash, which would not be reflected on the P&L. In this narrative, the P&L may look good, but the balance sheet fills in the gap. Even though expenses are not high (i.e., not much water is flowing out of your bucket), your profits may be low. The balance sheet shines light on your cash getting tied up in assets.
Example 3: Consumer Products Companies or Companies with Inventory
Inventory companies that sell a product, may have a ton of cash tied up in inventory. This could be due to any number of reasons: They have bought up too much of the wrong product, are stuck with stale product or perhaps have a few million old models of computers or an old version of software, etc.
Your P&L hides this, but your balance sheet exposes it. The inventory will show up on your balance sheet as cash that has already been spent.
The Importance of the Three-Pronged Approach to Financial Reporting.
Along with the statement of cash flows, the P&L and balance sheet are often part of a three-pronged approach to financial reporting. Don’t forget that your balance sheet tells you how efficient business is at turning profits into cash. But the balance sheet doesn’t tell you about your revenue, income or cash flow, so should be used together with the other two reports. All of these financial reports are important for investors or stakeholders to review to understand the value and health of your company.