In the following guide, we’ll explore the role of these financial statements to show how useful they can be to your business.
Income statements: show you what you’re working with
An income statement (also called a profit and loss statement) tells you how much money your business made, and how much it spent, over a particular period. By going back and looking at trends in your income statements, you can track your financial health, and find ways to improve your profit margin or increase cash flow.
How to prepare an income statement
Income statements are prepared monthly, quarterly, and annually. However, they can be created for any time period you like. There are three steps to creating one:
Collect every journal entry made over the period of time in question
Total all the categories of expenses and revenues.
List the totals for each category—first revenue, then expenses.
By subtracting all your expenses from your revenues, you get your net income (also known as the bottom line.) This is the money you keep as profit.
Preparing an income statement: an example
Suppose Steam, a major game company, creates an annual income statement.
First they organize their revenue from the three types of games they make: First-person shooter (FPS) games, Real-Time Strategy (RTS) games and Role Playing Games (RPG).
The first part of the income statement would look like this:
|Revenue from FPS||$50M|
|Revenue from RTS||$50M|
|Revenue from RPG||$50M|
Once they’ve listed their total revenue, the accountants at Steam need to list their total expenses.
To do that, they add up amounts from all their expense categories:
|Game development expenses for FPS||$30M|
|Game development expenses for RTS||$30M|
|Game development expenses for RPG||$30M|
|Delicious beef jerky||$5M|
The accountants track expenses related directly to game development, plus other expenses they need to keep their business running. In this case, it’s beef jerky to feed hungry game developers.
Finally, with revenues and expenses accounted for, we calculate the net profit by subtracting expenses ($97M) from revenues ($150M):
Total profit: $53M
The income statement shows that Steam was able to earn $53 million dollars for the year.
Heads up: If your business uses the accrual method of accounting, your income statements report assets and expenses as they’re incurred, rather than when you actually earn or spend cash. In order to know how much cash you have to work with, you need to prepare cash flow statements.
The next financial statement, the balance sheet, helps tie together what the retained earnings mean to the overall value of the company.
Balance sheets: show you the big picture
The balance sheet tells you what you own, what you owe, and what’s left over. In other words, your company’s balance sheet shows you your current assets, current liabilities, and owner’s equity (or shareholders equity if you’re a corporation). That information tells you what your company is worth at a specific point in time.
How to prepare a balance sheet
Preparing a balance sheet is similar to preparing an income statement—with three major differences:
Instead of revenue, you add up your assets
Instead of expenses, you add up your liabilities
Instead of net profit, when you subtract your liabilities from your assets, you get your owner’s equity
Listed before liabilities, the assets category includes both tangible assets (cash, inventory, real estate, company stock) and intangible assets (trademarks, patents, reputation, your client list).
Listed after assets, the liabilities category includes both short-term liabilities (money you need to pay back before the end of the the year) and long-term liabilities (money it will take you more than a year to pay off).
Continuing with the example from video game maker Steam, their asset categories are totaled and listed as follows:
Next, their liabilities and equity categories are totaled and listed as follows:
The information you can get about a company from both the income statement and balance sheet is useful. For example, Steam had a profitable year (from the income statement) and their assets outweigh their liabilities (from the balance sheet) which puts them in a strong financial position.
Further reading: How to Read (and Analyze) Financial Statements
The bottom line
This is just a brief example of the accounting dynamic duo in action. These two financial statements can do much more for a business. As a team, income statements and balance sheets work together to show just how well the company is performing, how much it is worth, and where there are opportunities to improve.
But financial statements are only as useful as the information you put in them—it’s essential to have accurate, up to date bookkeeping. Need a bookkeeper? Check out Bench. We’ll do your bookkeeping for you, and give you simple, digital financial statements every month. Learn more.