Balance Sheet Versus Income Statement

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Balance Sheet Versus Income Statement

A balance sheet differs from an income statement in terms of what it describes. An income statement covers a range or period of time such as a month or a year. An income statement describes how much money came into an organization during a period of time, how much went out as expenses, and what was left at the end of the period. A balance sheet is usually generated to show a snapshot of what an organization owns or owes on the last day of the period covered by the income statement. The balance sheet describes what the organization owns or owes to keep making or paying money during the next period of time covered by the next income statement.

As an analogy, say that two individuals tracked how much salary each brought in during the year and what expenses each had during that year. At the end of the year, these individuals find that they started with exactly the same salary, had exactly the same amount of money go out as expenses, and had exactly the same amount of money left as a net profit or loss at the end of the year. If you were to examine their balance sheets, however, you would find two very different pictures. Much more of the first person’s expenses went toward buying stocks, bonds, and real estate. The second person’s expenses went to into buying the latest fashions and taking lavish vacations. At the end of the year, the first person’s investments paid off, consequently, he or she has much more in personal assets than in debts. The second person has less in assets and much more in debt.

The types of things that each person owns and owes are very different. Likewise, the proportion (or balance) of the amount each owns versus the amount each owes is very different. Finally, the first person is in a better position to make even more money in the next time period because his or her investments should help generate even more revenue. The second person is not in as good a position to bring in as much money next year. If the first person becomes unemployed, there is a cushion (some assets) to fall back on at least for a little while! The second person would be in a tough spot if he or she were laid off because there is no asset “cushion” to weather a period of unemployment.

In essence, the income statement tells you how much money came in and how much went out. The balance sheet tells you what the money turned into. The statements are related but different. A good manager or a good WLP professional must understand both.

Dissecting a Balance Sheet

On a balance sheet, the total amount of assets must always equal the total amount of liabilities and owner’s equity. The balance sheet changes constantly. Money flows in and out of an organization as it receives payments, purchases goods, and makes other daily transactions. For this reason, the balance sheet is considered a snapshot of the mix of assets, liabilities, and owner’s equity on a single specified date.

In reality, there can be many unique types of assets and liabilities that an organization can use to produce income. Senior managers must manage the relative proportion of each type of asset, liability, and owner’s equity within the balance sheet and between the balance sheet and the income statement. Whether the organization is maintaining the appropriate proportions, or balance, is tracked by calculating ratios of how big one item is relative to another.

When communicating value, it is important to know that every item on a balance sheet has an optimal range for its size. What that optimum is varies depending on the organization and its industry norms. It will be important for you to discover the appropriate proportions for your target organization because anything that is out of proportion may signal a financial problem. If you can offer interventions that create better proportions, you will get the attention of your audience.

On a balance sheet, assets that will be converted into cash within a year are known as current assets.

A common example of a long-term asset is a manufacturing plant. ABC MediCompany’s manufacturing plants are included under the item known as “property, plant, and equipment.” Liabilities that will be paid within a year are known as current liabilities. Liabilities that will not be paid within a year are known as long-term liabilities.

The items on a balance sheet can be listed in any order. For assets, cash is often at the top of the list. Some accountants list items in order of their size. Others list assets in the order in which they can be most easily converted to cash, with cash being at the top of the list. Converting an asset into cash is called making the asset liquid. The easier it is to turn something into cash, the more liquidity the item has. Liabilities can be listed in the same way, with the items needing the most immediate use of cash listed first. Other liabilities and then the owner’s equity may follow in descending order of their need for cash.

Checking the Balance: Ratios
Now that you have a basic understanding of the items contained in the income statement and contained in the balance sheet, it is time to compare the size or proportion of different items to each other. This comparison is known as checking the balance, or the ratios, of an organization. Ratios tell Senior managers and savvy WLP professionals where problems exist and can hint at what interventions might create the most value by bringing the items back into balance.