The Difference Between a Balance Sheet and Your P&L (And Why it is Important)
We often see prospective clients paying special attention to the profit and loss statement (P&L), but ignoring the balance sheet. This is a mistake, as both are important. Consider this to be your cheat sheet. Let’s drill into their differences:
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).
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, and it is often required by lenders to obtain a loan. 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.
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, they should also regularly be reviewing their balance sheet.
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.
Assets – Liabilities = Equity
Still not clear on what the difference between the P&L and your balance sheet is? Here are a few examples:
- 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 do not 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).
- 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.
- 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 the balance sheet are often part of a three-pronged approach to financial reporting. Do not forget that your balance sheet tells you how efficient business is at turning profits into cash, and all of these financial reports are important for investors or stakeholders to review to understand the value and health of your company.
Stay tuned for our upcoming blog on troubleshooting cash flow issues.
For more information, contact Chris Arndt at firstname.lastname@example.org or at 312.494.7014. Visit ORBA.com to learn more about our Cloud CFO Services.
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