The income statement shows you how profitable your business is over a given period (through revenues and expenses), while the balance sheet gives you a snapshot of your assets and liabilities. Together, they’re a financial force to be reckoned with.
In the following guide, we’ll explore the role of these financial statements to show just how useful they can be to your business.
Income statements: show you what you’re working with
To find out how revenues and expenses contribute to profitability across a period of time, an income statement is prepared. Typically income statements are prepared monthly, quarterly, and annually, however they can theoretically be calculated over any time period.
Preparing an income statement is fairly straightforward. First, every journal entry made over the time period in question is collected. Next, all the categories of expense and categories of revenues are totaled. While it sounds easy, depending on the number of transactions, this process can be time consuming and it’s generally the step that computers help the most with.
Once the totals for each category of revenue and expense are prepared, they are then listed with revenue categories first followed by expense categories.
For example, consider how the video game maker Steam could organize their annual income statement. First they would organize all of their sources of 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
Total revenues: $150M
Of course, revenue is only half the picture of the income statement. The total expenses Steam incurred to generate revenue need to be accounted for.
To do that, all of the expense categories, including those that are indirectly related to game development, are tallied as follows:
Game development expenses for FPS: $30M
Game development expenses for RTS: $30M
Game development expenses: $30M
Hosting expenses: $2M
Delicious beef jerky: $5M
Total expenses: $97M
Finally, with revenues and expenses accounted for, it is possible to calculate the all-important profit by subtracting expenses ($97M) from revenues ($150M):
Total profit: $53M
In this fictitious example, the income statement shows that Steam was able to earn $53 million dollars for the year. Interestingly, the income statement is also where the impact of certain costs, such as beef jerky, show their impact to the bottom line of the company.
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
By knowing what a company owns (assets), what it owes (liabilities) and what is left over for the company owners after paying off any financial obligations (owner’s equity), it is possible to understand what the company is worth at a particular moment in time.
The balance sheet is precisely the financial statement that helps to communicate all of these pieces of information about a business to those who might be interested in knowing, such as creditors, investors, and owners.
Calculating a balance sheet is similar to calculating an income statement, with two notable differences. First, instead of the revenue and expense categories, the categories to be totaled are called assets, liabilities, and equity categories. Second, instead of only counting journal entries from a defined time period, the balance sheet takes into account every journal entry the company has ever made since it was founded.
Continuing with the example from video game maker Steam, their asset categories are totaled and listed as follows:
Bank account: $80M
Accounts receivable: $2M
Computer equipment: $10M
Office building: $40M
Total assets: $132M
Next, their liabilities and equity categories are totaled and listed as follows:
Accounts payable: $15M
Long-term debt: $40M
Total liabilities: $55M
Share capital: $20M
Retained earnings: $120M (the sum of all revenue and expense ledgers of the company for all time)
Total equity: $77M
The information that can be obtained about a company when looking at both the income statement and balance sheet is substantial. 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.
The bottom line
While this is just a brief example of the accounting dynamic duo in action, these two financial statements can do way 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 opportunities exist to improve the business.
These statements, however, will only be as good as the information that goes in them, which is why one of the best things any company can do is to ensure it keeps the bookkeeping up to date and maintains organized financial records.