Article
Written by Alice Payne
Posted on 01/07/2015

How to understand financial statements: balance sheet vs profit and loss account

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Balance sheet vs P&L account

Balance sheets and P&L accounts can give you rich insight into a company’s value. A balance sheet is an overview of a company’s assets, liabilities and equity capital. It’s a reflection of the company’s value at the end of the financial year. The P&L account provides an overview of all the company’s revenues and expenses. You can use this information to calculate the operating profit.

A closer look at balance sheets

The balance sheet, quite simply, balances debit (or assets) against credit (or liabilities). These two columns should always equal the same amount.

Assets are items like cash, goods, buildings or receivables, and also include financial assets such as subsidiaries, and less tangible assets such as goodwill. As there are many different types of assets, these are then broken down into fixed assets and current assets.

Fixed assets are ‘fixed’ for longer than a year and include:

  • Tangible fixed assets: the tangible items that service business operations for the longer term, such as buildings, inventory, vehicle fleets and computer equipment
  • Intangible fixed assets: the intangible and non-financial costs that play a role in the financial process but not the physical business, such as start-up costs and licences, patents, goodwill, research and product development costs
  • Financial fixed assets: investments, for example in other businesses.

Current assets are items that can be converted to cash within one year and include:

  • Inventory: finished products or goods in the company that serve to create products. Inventory also includes maintenance products and packaging materials
  • Receivables: outstanding customer accounts and prepaid expenses, such as VAT and receivables
  • Liquid assets: financial resources that are immediately available, such as bank accounts and cash.

The balance sheet’s liability column shows the company’s liabilities and equity capital. This can include long-term liabilities, like a mortgage, or short-term liabilities, like payables. It’s broken down this way:

  • Equity capital: the amount the business owner or shareholders have invested in the company. This money is considered a debt because it’s actually lent to the company, which is why it’s on the credit side of the balance sheet. The equity capital balances the balance sheet. If the assets are greater than the liabilities, that’s called positive equity capital. If the liabilities are greater than the assets, there is negative equity capital
  • Facilities: where the amounts to meet potential future obligations are booked, such as pension provisions and remediation costs
  • Long-term liabilities: includes liabilities that run for more than a year, such as mortgages, bonds, leases, as well as debts with lending institutions, shareholders and subsidiaries
  • Short-term liabilities: funds available to the company for less than one year, such as salaries, taxes and payables.

The assets are always equal to the liabilities. This is called the balance sheet total and shows the company’s size in comparison to others in the same industry.

A closer look at the P&L account

The P&L account, also called the income statement, is a snapshot of a company’s financial state for the entire financial year. The results are usually divided into three:

  • Gains/losses from normal business operations: This shows a company’s normal turnover minus its normal expenses.
  • Unusual gains/losses: This involves a gain or loss from an unusual incident, one-off event or a gain or loss of unusual size.
  • Extraordinary gains/losses: These don’t originate from normal business operations, for example they could come from the sale of a business unit.

The P&L items are usually listed in order and divided into operating income and operating expenses. Operating income is the net turnover, which means it excludes VAT. Operating expenses are the various expenses to keep the company operating, and can include trade goods, services, salaries and raw materials.

Calculating net profit

Net profit is the final gain or loss once you’ve deducted all expenses, interest expenses, interest income and tax. Which means it’s a very critical figure when examining a financial statement. Thankfully, there’s a simple formal for calculating this:

operating income - operating expenses = operating profit (operational gains/losses)

+

interest expenses - interest income = gross gains/losses (gains/losses before tax; gross profit)

– taxes payable

= net profit.

This article is part of our series on reading financial statements, which you’ll be seeing more of over the next few weeks. Watch this space for our Reading a Financial Statement for Dummies guide – coming soon.