Profit and loss statement vs. balance sheet: Which one should I use?

There are many documents a small business needs to operate its business, including a variety of tax forms and financial statements. It's easy to get confused with all the information your business needs to track.

Within the category of financial statements, the profit and loss statement—also known as the income statement—works alongside the balance sheet, and yet each serves a different function in helping you manage your small business.

Profit and loss statement for small business

The purpose of the profit and loss statement, also referred to as the P&L, is to show you, and any investors, whether your small business is profitable. A profit and loss statement displays the company's revenue and expenses, which, when combined, result in the net income. Not only does the P&L show investors how a small business is doing overall, but also the small business can use the P&L to find out which expenses are too high, which expenses to limit, and what the business's revenues actually are. The small business owner can then focus on what needs to be done to improve the business's net income.

A P&L is arguably the most important financial sheet your small business has. It shows the company's net income over a period of time, which can be monthly, quarterly, or yearly. It's up to you, as the business owner, to determine how often you want to create a P&L. Choose a frequency that will help you see the overall picture of how the business is doing and how it can improve. It's also a good idea to compare present P&Ls to prior years' P&Ls to see if (and how) the company's net income is increasing or decreasing over time.

How to create a profit and loss statement

If you're doing a yearly P&L, then the profit and loss statement includes all income or sales for the year and all expenses for the year. Income also includes cash received. Because you must account for all sources of income and all expenses, it's important for you to keep accurate business records.

You may want to have your accountant prepare the P&L for you, since the profit and loss statement must also include cost of goods sold, taxes, and interest expenses. Some business software can help you prepare it yourself, but it's up to you as to whether you think you can prepare it accurately or whether you would rather have a financial advisor or accountant do it for you.

While doing the P&L yourself may not sound all that difficult—starting with revenue and then subtracting the operating expenses to end up with the net income—you must do it correctly, in order to yield information you can use. When in doubt, consult your accountant. The details are important because they also show potential lenders if the business can pay its debts.

What is on a balance sheet

The balance sheet—as opposed to the P&L, which shows results over a defined period of time—provides a "snapshot" of the business's performance as of a given date. The balance sheet not only includes the business's assets and liabilities, but also the owner's equity in the business, as well as any long-term investments.

The basic formula for the balance sheet is: Assets = Liabilities + Shareholders' (or Owner's) Equity. Because the balance sheet is more detailed then the P&L, you are well advised to seek help from an accountant before trying to prepare the balance statement yourself. Nevertheless, some small business owners like to do their own balance sheets.

How to Make a Balance Sheet

There are plenty of software options to help you with preparing the balance sheet, should you decide to do this yourself. First, you must figure out the business's revenue or assets from all sources, including accounts receivable and cash. Next, calculate the liabilities and expenses, such as taxes owed, wages, and mortgages. The assets and liabilities must include all large and small amounts as of the given date. The owner's (or shareholders') equity is the difference between the assets and liabilities.

Which one should I use?

The simple answer is: both. The P&L, the balance sheet, and the cash flow statement are the three financial statements that work together to measure your business's financial health and thus are necessary for you to prepare. If you want to see if your company is in the red or in the black, prepare the P&L first. If you want to see what your equity is, you'll need to see the balance sheet.

To stay on top of your company's financial performance, it's important to use both the P&L and the balance sheet. What's the relevant time frame? If you want to know how your company is doing right now, then use the balance sheet. If you want to see how your company has performed over the past year, use the P&L.

Contact your financial advisor or accountant to help you if you're unable to prepare these statements on your own. Many companies turn to their accountants to prepare these statements because they can be complicated and take a lot of time and effort. Don't be afraid to call your accountant if you think you're getting in over your head. The financial health of your small business depends on your being able to see and interpret these critical financial details.