If you’re thinking about operating a business in the United States, you’ll want to get familiar with balance sheets and income statements. These are two documents that are critical to understanding your company’s financial health from two different perspectives.
At Remitly, we’re committed to supporting you in your financial goals as you settle in a new country. If you’re just starting out in the US, this article will tell you everything that you need to know about balance sheets and income statements, including their key differences.
Understanding balance sheets and income statements
When I started a limited liability company (or LLC) in the US, I was inundated with forms, reports, and paperwork to fill out. Understanding everything felt like an impossible—but imperative—task. Managing the paperwork behind the operation of your business is key to maintaining good financial health and compliance. Let’s look at two important financial documents:
- Balance sheet: A balance sheet is a document that shows a company’s present financial position in terms of assets, liabilities, and equity. You can think of a balance sheet as a “receipt” of a business as it presently stands.
- Income statement: An income statement is also referred to as a statement of profit and loss (P&L). It shows a company’s revenue, expenses, and net income or loss over a specific period of time. An income statement usually shows either a quarter or an entire fiscal year.
Their role in your company’s financial health
To fully understand a business’s financial condition, you need to consider both balance sheets and income statements.
Imagine the following scenario. You see the balance sheet of a company that shows tons of assets and few liabilities. You’d think that this business is going strong. However, if you take a look at the income statement from the last fiscal year, you see that there is a net loss. When taking both documents into consideration, you’d realize that the company could be headed towards some difficult financial times and might have to liquidate some of its assets.
On the other hand, if you see a balance sheet that shows a brand new company with few assets and many liabilities, you might feel that things aren’t going so great. However, the company’s income statement shows big gains in the last quarter. These could be the financial documents of a startup that’s about to be incredibly successful.
By reviewing both the balance sheet and the income statements of a business, you’re able to see the company holistically.
A closer look at financial statements
Now that you have some understanding of balance sheets and income statements, let’s talk a little bit about why they’re important.
The role of financial statements in business
Keeping a good record of your business’s finances is a good practice as a business owner. However, it becomes even more important as your business grows or other people start to get involved. Financial statements are imperative documents in three different business contexts:
- Taxation: Keeping accurate financial records makes filing your taxes easier for you or for any accountant to whom you outsource this task. In case of any audits, having accurate and comprehensive records will make the process easier and less stressful.
- Financing: Studying your own financial documents can help you make decisions about how to best allocate funds for your business. Financial documents can also be leveraged when applying for business credit cards or business loans.
- Investing: Anyone looking to invest in your business will want to have all of the information necessary to decide how risky the investment would be and if they’d have a return on investment. Presenting potential investors with sufficient information in the form of financial statements makes this decision easier for them—and potentially better for you and your business.
Key components of financial statements
Business documents are filled with jargon and words that might not mean anything to you if you don’t have a background in finance. I know from personal experience that plenty of small business owners are mostly interested in their craft, whether it be hairstyling or carpentry. Administrative tasks tend to require lots of research and tutorials if you take them on yourself. But with the right support and knowledge, everything is manageable.
To jump-start your understanding of financial documents, let’s start by learning some key terms that you’ll find on balance sheets and income statements:
- Quarter: This refers to a three-month period, or one quarter of a year
- Fiscal year: A year as measured for taxation or financial reporting
- Asset: Any item of value owned by a company, whether tangible or intangible
- Liability: Any debt or financial obligation that a company owes to another party
- Equity: The ownership and value of a company, usually represented in percentages
- Revenue: The total amount of money a company earns from its primary operations, like sales of goods or services rendered
- Expense: A cost incurred in the ordinary course of business or operation of a company
- Income: Money earned by a company when revenue is greater than expenses
- Loss: Money lost by a company when revenue is less than expenses
How balance sheets and income statements fit in
There are many different documents that speak to a company’s financial health, including tax records and invoices. However, balance sheets and income statements provide a unique look into your company’s financial status, both at a specific point in time and over a period of time in the past.
Understanding the balance sheet
A balance sheet gives up-to-date “real-time” information about a company’s present financial standing based on everything it owns, everything it owes, and its ownership. Here, we’ll dive into the aspects that make up a balance sheet.
Components of a balance sheet
- Assets: Everything a company owns will be reported on a balance sheet. This includes things like cash, accounts receivable (money owed by customers), inventory, physical buildings, and equipment.
- Liabilities: This information shows everything a company owes to others. This includes accounts payable (money owed to others), loans, and salaries to employees.
- Shareholder equity: Equity is the “bottom line” of a balance sheet and is calculated by subtracting the liabilities from the assets. This remainder is the amount of the company that belongs to its owners. In other words, it’s like the “net worth” of a company.
Snapshot of your financial position
Ultimately, the balance sheet is the best document for understanding a company’s current financial position. However, it doesn’t show how a company is operating or whether it is likely to improve or worsen financially.
Decoding the income statement
Income statements report a company’s performance during a designated period of time in the past. These documents show how money moves through a company based on what is spent, what is earned, and what is gained.
Components of an income statement
- Revenue: The total amount of money that a company makes in the designated period of time
- Expenses: The total amount of money spent to generate revenue and continue the regular operation of the business
- Net income: When you subtract the expenses from the revenue, you have the net income of the business. If this is positive, you have a profit. If it is negative, you have a loss.
Insight into financial position over time
An income statement shows the performance of a company over a period of time, allowing a reader to understand financial trends and history. However, the income statement does not speak to a company’s current financial position. For example, a company that suffers a loss during one quarter might have plenty of assets and still be in a great financial position, or vice versa.
The bottom line
Financial statements are important for any business and knowing how to understand them is essential for you as a business owner. Balance sheets and income statements individually provide different information about a company. Together, they show a holistic view of a company’s financial health and history.
Key differences between documents
A balance sheet provides a snapshot of your company’s current financial position. This makes balance sheets a great way to report how your business is doing, financially, in the present moment.
Income statements, on the other hand, show how your business has performed in the past. Often, they show a quarter or an entire physical year. This longer period of time makes income statements useful in understanding trends and patterns in your company’s finances.
Tips for business professionals and entrepreneurs
If you’re just starting out with your own business, here are some tips that can help you get over the hurdle of understanding, organizing, and leveraging your company’s financial documents.
Learn as much as you can
As I mentioned before, most people who are starting a small business don’t have a background in business. That’s okay! However, it’s important that you know what you don’t know and inform yourself accordingly.
Develop a system
Keeping track of your business’s finances can be a daunting task, but it’s made easier if you have a clear go-to system to do so. Maybe you’re a small enough operation that you can manually track your payments and expenses. Maybe you elect to use an automated bookkeeping program that generates financial reports for you. Either way, having a system in place is key.
Keep accurate records
Once you choose a system for tracking your business’s finances, it’s important to stick to it. Keep accurate records so that your financial reports generated by these data points are accurate, too.
Review your documents regularly
It’s important to monitor your business finances closely on both the small scale and in the bigger picture. On a frequent basis, this might mean following up on invoices that are pending as well as tracking your expenses. In the longer term, this could be studying your balance sheets and income statements to try to notice trends and areas to improve.
Hire a professional when necessary
If you’re finding the financial management of your company daunting or confusing in any way, consider hiring a professional. Outsourcing your accounting or having a financial advisor for the business could free up your time and energy to focus on aspects of the business that really make your heart sing while leaving the number crunching to someone who loves that.
Additional resources for further learning
There’s so much to know about financial health and wellness for small business owners and entrepreneurs. If you’re hungry for more information, check out these additional resources:
- Harvard Business School’s free guide on how to read financial statements
- Duke University’s free 2-hour online workshop, providing an overview of financial statements
- Coursera’s free 2-hour online workshop on how to write financial statements in Microsoft Excel
FAQs
What are the three main differences between balance sheets and income statements?
The three main differences between these two financial documents are the reporting period or amount of time that they reflect, the focus on past performance vs current position, and what elements are included in the statement.
Does my income statement have to match my balance sheet?
No. Your income statement and balance sheets are two separate financial statements that each reflect the company’s financial position from different perspectives.
How can I approach “bad debt” via my balance sheets and income statements?
Bad debt refers to uncollectible accounts. In other words, someone was supposed to pay your business, and they didn’t. To deal with this scenario on a balance sheet, use what’s called the “allowance method” by estimating the amount of bad debt for that period and subtracting it from the gross amount of accounts receivable. To deal with bad debt on your income statement, you can reflect it as an administrative expense.