Accounting Standards: What are Profit and Loss and Balance Sheet Reports?
We’ve been talking about Accounting Standards in the last few blog posts, and if you haven’t read those yet, please go back and do so. I am approaching this post as if you have a certain baseline of knowledge on what we’ve been talking about thus far. I know Profit and Loss and Balance Sheet may not be the MOST enticing topic. Still, these concepts should be important to every business owner and entrepreneur out there. My goal is to help demystify these two essential financial statements.
Profit and Loss Financial Statement
Often referred to as the “P&L,” its purpose is to provide the owner with critical performance analysis. The P&L, at a glance, can give the business owner an assessment of profitability by calculating its net income (or net loss). Net income is calculated using the difference between total revenue and expenses year-over-year (or month-over-month). Another critical aspect of the purpose of the P&L statement is providing an analysis of financial performance to stakeholders (i.e., board members, investors, etc.). Finally, the P&L statement is one of the most powerful tools that you, as a business owner, can use in your business for budgeting, forecasting, and long-term decision-making.
In this previous blog post I mentioned that the P&L is divided into two sections. The top section is the Revenue/Income section.
The most common Income sources for small businesses would be:
Sales of Goods and Services - The primary income source for most small businesses is the sale of products or services. This includes retail sales, service fees, consulting fees, or any revenue from the core business activities.
Subscriptions and Membership Fees - For businesses offering recurring services or access to exclusive content, subscriptions and membership fees can be a steady income source. This model is standard among software companies, content providers, and clubs or associations.
Commissions and Fees - Businesses that act as intermediaries, such as real estate agencies, travel agencies, or affiliate marketers, earn income through commissions and referral fees. This income is generated by facilitating transactions or promoting third-party products and services.
Rental Income - Some small businesses generate income by renting out properties, equipment, or other assets. This includes commercial real estate, event spaces, tools, or machinery that can be leased to other businesses or individuals.
Licensing and Royalties - Businesses that develop intellectual property, such as software, patents, or creative content, can earn income through licensing agreements and royalties. This allows other entities to use the intellectual property in exchange for a fee or a percentage of sales.
The bottom section of the P&L for Expenses will include categories such as cost of goods sold (COGS), operating expenses, interest, and taxes. These expenses are essential for the ongoing operations of a small business and should be carefully managed to ensure profitability and sustainability. Some common operating expenses for small businesses would be:
Rent or Mortgage Payments - If a small business operates from a physical location, rent or mortgage payments for office space, retail storefronts, or warehouses are significant recurring expenses.
Salaries and Wages - Employee compensation, including salaries, wages, and benefits, is often the largest expense for small businesses. This includes full-time and part-time employees and any contracted or freelance workers.
Utilities - Utilities such as electricity, water, gas, internet, and phone services are not unexpected costs but regular and predictable parts of your operating expenses. By factoring them into your budget, you can ensure your business runs smoothly and without surprises.
Marketing and Advertising - Expenses related to promoting the business, including digital marketing, print advertising, social media campaigns, and other promotional activities, are not just costs but investments in your business's future. They are crucial for attracting and, more importantly, retaining customers ensuring a steady stream of revenue.
Office Supplies and Equipment - Costs associated with purchasing and maintaining office supplies and equipment, such as computers, printers, furniture, and other necessary tools, are common operating expenses for small businesses.
Performance Measurement
At the end of every month it’s important to analyze your P&L statement so that you can identify which products or services are most profitable, where expenses are highest, and how different strategies impact the bottom line. This information is invaluable for making informed decisions about pricing, cost management, and resource allocation.
Overall, the P&L statement is a vital report that offers insights into a business’s profitability, guiding strategic planning and operational adjustments to ensure long-term success.
Balance Sheet Financial Statement
Often referred to as simply the "Balance Sheet," it provides a snapshot of a business's financial position at a specific point in time. It lists a company's assets, liabilities, and equity. The fundamental accounting equation that underlies the Balance Sheet is:
Assets = Liabilities + Equity
This equation ensures that the Balance Sheet always balances. There are a few potential sections in your Balance Sheet. The following will detail the possible categories and accounts found in each section.
Current Assets:
Current assets are expected to be converted into cash or used up within one year or one operating cycle, whichever is longer. They are critical for managing short-term financial obligations and liquidity. Examples include:
Cash and Cash Equivalents - These are the most liquid assets, including currency, bank balances, and short-term investments that can be readily converted to cash.
Accounts Receivable - The money owed to the business by customers for products or services delivered but not yet paid for, is a crucial part of the cash flow cycle. Accounts receivable is typically collected within a few weeks or months.
Inventory - Goods available for sale, including raw materials, work-in-progress, and finished goods. Inventory value varies based on the inventory accounting method (FIFO, LIFO, or weighted average).
Non-Current Assets:
Non-current assets, also known as long-term assets, are assets that are expected to provide economic benefits beyond one year. They are less liquid and are used to support long-term business operations. Examples include:
Property, Plant, and Equipment (PP&E) - Tangible assets such as buildings, machinery, and vehicles used in the business. These assets are depreciated over their useful lives.
Intangible Assets - Non-physical assets such as patents, trademarks, copyrights, and goodwill. Intangible assets provide competitive advantages and can be amortized over their useful lives.
Liabilities:
Current Liabilities
Current liabilities are obligations that a company must settle within one year or one operating cycle, whichever is longer. They are used to assess a company’s short-term liquidity and financial health. Examples include:
Accounts Payable - Money owed by the business to suppliers or vendors for goods and services received but not yet paid for. This is typically due within a few months.
Short-Term Debt - Loans or other borrowings that are due within one year. This can include bank loans, lines of credit, and the current portion of long-term debt.
Long-Term Liabilities
Long-term liabilities are obligations that are due beyond one year. They are used to finance long-term investments and growth initiatives. Examples include:
Loans and Bonds - Debt instruments issued to raise capital. Loans and bonds have varying terms and interest rates, and they are repaid over several years.
Deferred Tax Liabilities - Taxes owed in the future due to temporary differences between accounting and tax treatments. Deferred tax liabilities arise from differences in depreciation methods, revenue recognition, and other accounting practices.
Equity:
Owners’ equity, also known as shareholders’ equity or stockholders’ equity, represents the residual interest in the assets of the business after deducting liabilities. It reflects the owners’ claim on the company’s assets and is an important measure of financial health. Components of owners’ equity include:
Common Stock and Preferred Stock - Equity investments made by shareholders. Common stockholders have voting rights, while preferred stockholders have priority over dividends and assets in case of liquidation.
Retained Earnings - Profits that have been reinvested in the business rather than distributed as dividends. Retained earnings are used to fund growth, pay down debt, or save for future needs.
Additional Paid-In Capital - The excess amount received from shareholders over the par value of the shares issued. This represents the additional investment made by shareholders in the company.
In my YouTube video, “How To Read Financial Statements - QBO Tutorial,” I detail some important concepts you should know when approaching your financial statements. I highly encourage you to watch this video if some ideas discussed in this blog post are challenging to conceptualize. One of the things I like about QuickBooks Online is its canned reports. QBO makes it easy to run reports on the fly. One of these reports (that I would say is a fav) is called the “Management Report.” This report encapsulates the “Profit & Loss” and “Balance Sheet” reports.
Disclaimer: This blog post is not a comprehensive guide to the FASB or FASB ASC as it relates to GAAP. Please consult your tax advisor or CPA for specific advice and guidance tailored to your business.
