In this lesson, you will learn about the standard organization of the income statement and the balance sheet. Specifically, this lesson will cover:
- Balance Sheet
- Owner's Equity
- Income Statement
- Net Income
1. Balance Sheet
The balance sheet, sometimes referred to as the statement of financial position, is a summary of the financial balances of the organization. A standard balance sheet has three parts:
- Owners equity
The main categories of assets are listed first, usually in the order of liquidity. Assets are followed by the liabilities, and the difference between the assets and the liabilities is what is known as equity.
It is important to remember that the balance sheet balances because of the fundamental accounting equation that says assets equal liabilities plus equity.
A balance sheet is often described as a snapshot of a company's financial condition. Of all the basic financial statements, the balance sheet is the only one that applies to a single point in time at the end of a business year.
Below is a sample balance sheet for a fictitious company, the ABC Company.
- Balance Sheet
- A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.
- 1a. Assets
Here we see assets
in the first section, with current assets listed first. Those are the ones that can be converted into cash very quickly in the short term, in less than a year, and they include cash, accounts receivable, what your customers owe you, inventory, prepaid expenses, and any short-term investments that you have.
The next subsection of assets is long-term assets or fixed assets. This includes longer-term investments, property, plant, and equipment, real estate less the depreciation, and any intangible assets as well. There's also a subsection for other assets like taxes. These assets are all totaled under the line item "Total Assets."
- Something or someone of any value; economic resources that represent value of ownership that can be converted into cash.
- Intangible Assets
- Identifiable non-monetary assets that cannot be seen, touched, or physically measured, and are created through time and effort, and are identifiable as a separate asset.
- 1b. Liabilities
Now let's take a look at the liability
section. Just as the current assets are listed first in the asset section, the current liabilities are listed first in the liability section. They include accounts payable, bills that you owe, short-term loans, income taxes you have to pay, and other accrued salaries and wages that have been expensed by the company but haven't been paid yet, along with any unearned revenue. Next are the long-term liabilities, which would include any long-term debt or deferred taxes.
- An obligation, debt or responsibility owed to someone.
- 1c. Owner's Equity
Finally, the last section is the owner's equity
. It includes the owner's original investment in the company plus any retained earnings. Those are net profits that have been earned over the life of the company. Together the owner's equity and the liabilities equal the total assets, so the balance sheet balances.
- The residual claim or interest to investors in assets after all liabilities are paid.
2. Income Statement
The income statement shows how the revenue is transformed into income. This statement has many names, including:
- Profit loss statement (P&L)
- Revenue statement
- Statement of financial performance
- Earnings statement
- Operating statement
- Company's financial statement
Revenue is the money that the company received from the sale of products and services before expenses are taken out. The income statement displays the revenue that is recognized for a specific period, and the cost and expenses charged against these revenues, like write off's in depreciation and taxes.
The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
The important thing to remember about an income statement is that it represents a period of time. This is different from the balance sheet, which represents a single moment of time.
Let's take a look at this sample income statement for XYZ Retailers.
- 2a. Revenue
The top section shows revenue, which includes sales; in this statement, sales represent a total of $250,000. We then subtract the cost of goods sold from this dollar amount. We figure this out by the change in the inventory, which gives us the gross profit. To the gross profit, we can add any other operating revenue not directly related to the business, such as rent or other commissions we might have received. This gives us the total revenue.
Generally, the total revenue is sales minus cost of goods sold.
- 2b. Expenses
The expenses section shows cash outflows, or any "using up" of assets or incurring of liabilities during the reporting period, from delivering your products, goods, or services or carrying out any other activities that are part of the major operations.
The first expenses listed are for selling, general and administrative expenses, often called SGA. SGA represents all the expenses needed to sell the products:
- Salary of salespeople
- Travel expenses
- Website design
These are all the expenses necessary to sell and deliver the products or services.
The last section shows non-operating expenses, like financing costs, income tax expenses, or other irregular items.
- 2c. Net Income
At the bottom, we show the net profit – the EBIT, or earnings before interest and taxes. For XYZ Company, $60,000 represents the net profit and it is called the bottom line. The bottom line is the net income that is calculated after subtracting all of these expenses from revenue. Since it is the last line of the income statement, it is usually informally called the bottom line and it's important to investors because it is the profit for the period, usually for the year, that represents the profit that is attributable to the shareholders.
In this lesson, we defined the balance sheet as the only statement that applies to a single point in time. The main categories of assets are usually listed first in order of liquidity, followed by the liabilities; the difference between the assets and the liabilities is known as equity.
Income statements display the revenues for a specific period, like an accounting year, and the cost and expenses charged against those revenues. The income statement shows a full accounting period; it starts with revenue and subtracts the cost of goods sold, providing the gross profit. It then lists all of the expenses, such as SGA, depreciation, and other expenses and irregular costs, to arrive at the bottom line, or net income.