The difference between the profit and loss account and the balance sheet
THe profit and loss and the balance sheet are two primary statements found in a set of financial accounts. This article explores the two statements and highlights the differences between them.
The differences between the profit and loss account and the balance sheet
A balance sheet is a primary statement in the financial statements that shows a “snap shot” of the company’s position at a particular point in time, which in the case of the annual financial statements will be the company’s period end, but in the case of management accounts, interim financial statements etc. it can be any date.
The top half of the balance sheet consists of the company’s fixed assets, current assets, current liabilities, long term liabilities and provisions, the summation of which is the net assets, or deficit, of the company. The bottom half of the balance sheet consists of the shareholder’s funds and all the other capital reserves, such as the profit and loss reserve (i.e. the retained profits of the company), the revaluation reserve (i.e. the excess in the current market value of properties and similar assets over the original cost) and any other applicable reserves.
When a company obtains external sources of finance such as bank loans and mortgages it is the balance sheet that show the level of security the company can offer. The stronger and healthier the balance sheet, i.e. the more security the company can give, the more chance the company will get the loan at a ‘good’ interest rate.
Profit and loss account
The profit and loss account is a primary statement in the financial statements (unless the company meets specific criteria in which case it does not have to be disclosed in the financial statements) that shows a company’s performance over a particular period of time.
Being a performance statement the profit and loss account informs the reader of the financial statements how the company has faired during the period and how much profit the company has generated or how much of a loss it has suffered. The profit and loss account consists of sales and other types of income, direct costs, overheads, interest and finance costs payable and the tax charge. The summation of the profit and loss account is the retained profit or loss for the period covered by the statement.
When a company obtains external sources of finance the profit and loss account is used to show the profitability, and give some idea of the cash generation, hence demonstrating the ability to repay the loan.
Despite being two totally separate primary statements the balance sheet and the profit and loss account are inextricably linked. As noted above the bottom half of the balance sheet contains the profit and loss reserve, which is the level of retained profits held within the company that have not been paid out as dividends to shareholders.
So in summary the balance sheet is a snap shot at an exact point in that shows the financial position of the company, where as the profit and loss account covers a period of time and shows the financial performance of the company.
In their own right the balance sheet and profit and loss account are useful statements, however they only show half the picture. In order to fully assess the worth of a company, or its performance it is important to look at both of these statements together.
The above is best explained by an example. Imagine a profit and loss showing a huge loss. If you were just looking at the profit and loss account this would be a cause for major concern. However, a look at the balance sheet shows the provisions have significantly increased and this is the reason for the loss. Provisions are purely an “accounting entry” that affect profit but not cash flow, so based on this the performance of the company is not so bad. If you didn’t have access to both statements.
Both the profit and loss account and the balance sheet are as important as each other and no single statement is considered to be more useful than the other. To fully appreciate what is going on in a company the reader of the financial statements needs to not only understand what a balance sheet and profit and loss account is but also the relationship between the two statements and how they interact with each other.