Running a small business comes with a hefty share of paperwork. As a small business owner, you might be asked to produce financial documents like balance sheets and profit and loss statements to show to current or prospective investors. These reports—which detail everything from a company’s revenue to its operating expenses and debts—indicate financial performance and help investors estimate a company’s net worth.
If you’re looking to attract investors, it’s worth untangling balance sheets and income statements, the two reports you’re most likely to encounter.
What is a balance sheet?
A balance sheet is a bird’s-eye view of a company’s finances, showing what it owns, what it owes, and how much its owners have invested. Balance sheets reflect the most up-to-date information about a company at the end of an accounting period.
More specifically, a company uses a balance sheet to report its assets, liabilities, and shareholder equity:
- Assets. A company’s assets fall into two categories. The first is short-term assets, which include cash on hand, cash equivalents, merchandise inventories, accounts receivable (money owed to the company by its clients), and short-term investments (like shares of stock that can be redeemed for cash in short order). The second category is long-term assets, which includes property, plants, and equipment (PPE)—the semi-permanent infrastructure a company needs to operate—and long-term investments and intangible assets, like patents and trademarks.
- Liabilities. A company also has short-term liabilities and long-term liabilities. Short-term liabilities, (i.e., current liabilities) include accounts payable (money owed to business partners) and accrued expenses (anticipated expenses treated as short-term debt). Long-term liabilities include employee salaries, rents, financial obligations to investors, and long-term debt payments.
- Shareholder equity. You can calculate shareholders’ equity by subtracting total liabilities from total assets. The difference represents the amount of cash the company would have if it sold all its assets to pay all its debts, reflecting the company’s net value as it pertains to shareholder ownership. Shareholder equity also includes a company’s retained earnings—monies the company will spend to build the business or pay down its long-term debt (lowering its debt-to-equity ratio).
As the name suggests, a balance sheet is built on a balanced equation, where a company’s total assets are equal to its total liabilities plus shareholder equity.
What is an income statement?
An income statement centers on the company’s revenue and expenses, focusing on its operating revenue, non-operating revenue, costs, and expenses over an accounting period. Also known as profit and loss statements (or P&L statements), income statements typically come out every quarter and can help company leaders conduct a financial analysis of their operations.
A company’s income statement may vary depending on its industry and activities during a reporting period. Some income statements contain granular detail, breaking down individual sources of revenue and expenses, whereas others emphasize topline numbers, offering a condensed snapshot of a company’s financial health. Most contain the following items:
- Revenue. Calculate revenue (net sales) by taking gross sales (total sales revenue) and subtracting returns, discounts to buyers, and negotiated allowances to buyers.
- Direct costs. Direct costs—or costs of goods sold (COGS)—represent expenses incurred through a company’s production process. This category includes raw goods, worker salaries, and depreciation expenses.
- Selling, generating, and administrative expenses. Commonly termed SG&A, this category accounts for all expenses unrelated to the direct production of goods, such as marketing and administrative staffing.
- Operating income. Calculate operating income by subtracting operating expenses from total income generated. Note operating income only refers to revenue and expenses connected to a company’s core business activities. Non-operating income (like interest income) might appear on a cash flow statement but stays separate from this line item.
- Interest income and expenses. A company can bring in non-operating revenue from interest payments. It can also have non-operating expenses by paying interest to its own lenders. Many income statements combine these into a topline item for net interest.
- Estimated taxes. Companies generate income statements before paying taxes but can still predict their tax liability and include it as a line item on an income statement.
- Net income. An income statement reveals a company’s net income (also called net earnings or net profit). When a company subtracts all its expenses from all its revenues, it establishes its net income for the given reporting period. Net income can be either positive or negative; some companies struggle to turn a profit and continually report negative net earnings, while others are profitable and report positive net income.
When are balance sheets and income statements required?
- To attract investment
- To file taxes
Investors and accountants are the two parties most interested in your business’s balance sheet and income statements. Here’s why:
To attract investment
If your company seeks capital from outside investors, expect those investors to request a balance sheet and as many income statements as possible. They use these documents to review a company’s revenue streams, ongoing expenses, and existing debt obligations.
- Balance sheets. Investors take particular interest in balance sheets because they reveal whether your company can build the long-term assets needed to keep up with the liabilities that inevitably arise as you do business.
- Income statements. The best way to analyze a business for investment purposes is to dissect its income statement. A single quarter’s income statement only reveals a sliver of a business’s financial position. Trends are more telling. Professional investors often review years of income statements to assess long-term trends and predict future profitability.
To file taxes
Professional accountants ask for income statements to calculate your company’s tax obligations and report them to the IRS. An annual income statement shows net profit for an entire year and is typically used to assess a company’s tax liabilities.
Balance sheets vs. income statements FAQ
Which is more important: an income statement or a balance sheet?
Active businesses must generate both income statements and balance sheets to attract outside investment and keep shareholders informed of the company’s financial position. Annual income statements are used to determine a company’s tax obligations to federal, state, and local governments. Both are essential financial statements, though balance sheets matter more to company leaders and their investors, while income statements matter more to tax accountants and governments.
What are three differences between balance sheets and income statements?
Key differences between balance sheets and income statements include: (1) reporting periods (most income statements come out quarterly, whereas balance sheets are less tied to specific accounting periods); (2) a focus on equity (balance sheets emphasize equity while income statements do not); and (3) detailed revenue streams (income statements often break these into more detail than balance sheets).
How are income statements, balance sheets, and cash flow linked?
Income statements, balance sheets, and cash flow statements are all financial reports that detail how money enters and departs a company. Cash flow statements go into the greatest detail about specific revenue sources and expenses. Income statements emphasize net profit within an accounting period. Balance sheets offer the broadest picture of the company’s overall financial health.