About Your Balance Sheet and Profit and Loss Statement

Assess your company’s financial status.

Long ago, we learned that success begins with building a relationship with customers. At First Financial Bank, you won’t find the same old cookie-cutter solutions. Our commercial lenders take the time to understand your business, so we can provide personalized service to help you succeed. Of course, it’s also important for you to understand how we view your business. And your balance sheet and profit and loss statement go a long way toward helping us understand where your business is today and how to help you plan for tomorrow.


When a creditor or investor asks how your company is doing, you'll want to have the answer ready and documented. The way to show the success of your company is with a balance sheet. A balance sheet is a documented report of your company's assets and obligations, as well as the residual ownership claims against your equity. Collectively, this information is used by lending institutions and investors to assess your company's financial status before lending money.

1. Who Wants to See Your Balance Sheet?

Many people and organizations are interested in the financial affairs of your company, whether you want them to be or not. You, of course, want to know about the progress of your company and what's happening to your livelihood. However, your creditors want assurance of your ability to pay them when they ask. Prospective investors are looking for a solid company to bet their money on, and they want financial information to help them make a sound decision. Your management group also requires detailed financial data, and the labor unions (if applicable) will want to know your employees are getting a fair share of your business earnings.

2. Common Classifications

On the balance sheet, your assets and equities are listed under classifications according to their general characteristics. It is a relatively simple matter to make a comparison of one classification with another or to make comparisons within a classification because similar assets or similar equities are listed together. Some of the most commonly used classifications are:


Cash is simply the money on hand or on deposit that is available for general business purposes. It is always listed first on a balance sheet. Cash held for some designated purpose, such as the cash held in a fund for eventual retirement of a bond issue, is excluded from current assets.


These investments are temporary and are made from excess funds that you do not immediately need to conduct operations. Until you need these funds, they are invested to earn a return. These investments should be made in securities that can be easily converted into cash, such as short-term government obligations.


Simply stated, accounts receivable are the amounts owed to your business and are evidenced on your balance sheet by promissory notes. You should label all other accounts receivable appropriately and show them apart from the accounts receivable arising in the course of trade. If these other amounts are currently collectible, they may be classified as current assets.


Your inventories include all products available for sale, in a partial stage of completion and any materials used to create your products. The costs of purchasing merchandise and materials and the costs of manufacturing your various product lines are accumulated in the accounting records and are identified with either the cost of the goods sold during the fiscal period or as the cost of the inventories remaining at the end of the period.


These expenses are payments made for services that will be received in the near future. Strictly speaking, your prepaid expenses will not be converted to current assets in order to avoid penalizing companies that choose to pay current operating costs in advance rather than to hold cash. Often your insurance premiums or rentals are paid in advance.


Investments are cash funds or securities held for a designated purpose for an indefinite period of time. Investments include stocks and bonds, as well as real estate or mortgages being held for income-producing purposes. Investments also include money held for a pension fund.


Often classified as fixed assets, or plant and equipment, your plant assets include land, buildings, machinery and equipment that are used in business operations over a relatively long period of time. It is not expected that you will sell these assets and convert them into cash. Plant assets simply produce income indirectly through their use in operations.


Your other fixed assets that lack physical substance are referred to as intangible assets and consist of valuable rights, privileges or advantages. Although your intangibles lack physical substance, they still hold value for your company. Sometimes the rights, privileges and advantages of your business are worth more than all other assets combined. These valuable assets include items, such as patents, franchises, organization expenses and goodwill expenses. For example, in order to become incorporated you must incur legal costs. You can designate these legal costs as organizing expenses.


During the course of preparing your balance sheet, you will notice other assets that cannot be classified as current assets, investments, plant assets or intangible assets. These assets are listed on your balance sheet as other assets. Frequently, your other assets consist of advances made to company officers, the cash surrender value of life insurance on officers, the cost of buildings in the process of construction and miscellaneous funds held for special purposes.


On the equity side of the balance sheet, as on the asset side, you need to make a distinction between current and long-term items. Your current liabilities are obligations that you will discharge within the normal operating cycle of your business. In most circumstances your current liabilities will be paid within the next year by using the assets you classified as current. The amount you owe under current liabilities often arises as a result of acquiring current assets, such as inventory or services that will be used in current operations. The amounts owed to trade creditors that arise from the purchase of materials or merchandise is shown as accounts payable. If you are obligated under promissory notes that support bank loans or other amounts owed, your liability is shown as notes payable. Other current liabilities may include the estimated amount payable for income taxes and the various amounts owed for wages and salaries of employees, utility bills, payroll taxes, local property taxes and other services.


Your debts that are not due until more than a year from the balance sheet date are generally classified as long-term liabilities. Notes, bonds and mortgages  are often listed under this heading. If a portion of your long-term debt is due within the next year, it should be removed from the long-term debt classification and shown under current liabilities.


Your customers may make advance payments for merchandise or services. The obligation to the customer will, as a general rule, be settled by delivery of the products or services and not by cash payment. Advance collections received from customers are classified as deferred revenues, pending delivery of the products or services.


Your owner's equity must be subdivided on your balance sheet: One portion represents the amount invested directly by you, plus any portion of retained earnings converted into paid-in capital. The other portion represents your net earnings that are retained. This rigid distinction is necessary because of the nature of any corporation. Ordinarily, stockholders, or owners, are not personally liable for the debts contracted by a company. A stockholder may lose his investment, but creditors usually cannot access his personal assets for satisfaction of their claims. Under normal circumstances, the stockholders may withdraw as cash dividends an amount measured by the corporate earnings. The distinction in this rule gives the creditors some assurance that a certain portion of the assets equivalent to the owner's investment cannot be arbitrarily withdrawn. Of course, this portion could be depleted from your balance sheet because of operating losses. The owner's equity in an unincorporated business is shown more simply. The interest of each owner is given in total, usually with no distinction being made between the portion invested and the accumulated net earnings. The creditors are not concerned about the amount invested. If necessary, creditors can attach the personal assets of the owners.


Ask yourself: Exactly how are my products and services affecting my business? How much money am I actually making because of those products and services? An income statement answers these and other financial questions. It tells you and any stockholders how your net assets have increased or decreased. On an income statement, the total inflow of net assets resulting from the delivery of services and products to your customers is measured in revenue accounts, which in turn tells you what caused the net assets to increase or decrease.

In addition, you can use an income statement as a tool to compare the most recent year with past trends, thus forming a reasonable forecast for the future. The statement also helps you locate problem areas regarding sales, margins and expenses, and provides a method for you to investigate problem areas within a reasonable amount of time. When an income statement is prepared properly, the net increase or decrease in your net assets, or the difference between revenue and expense, is designated as net income or net loss. A net increase in net assets or net income is then added to your equity on your balance sheet.

This tool examines the process of developing an income statement and explains the meaning of its components. When finished, you will have a greater insight into your company's growth and financial health.

1. Elements of Income

The elements of income are generally divided into four categories: revenues, expenses, gains and losses. Revenues are inflows or other enhancements of financial assets of your business. They may also be settlements of your liabilities from delivering or producing goods and services, or engaging in other activities that constitute your company's ongoing major or central operation. Expenses, on the other hand, are outflows of assets or incurrences of liabilities from delivering or producing goods and services, or carrying out other activities that constitute your company's ongoing major or central operations. When gains are reported, they represent increases in net assets from peripheral or incidental transactions and from all other transactions, events and circumstances affecting your company, except those resulting from revenues or investments by owners. Losses are reported when your company's net assets decrease.

2. Income Determination

Your income is measured as the difference between resource inflows (revenue and gains) and resource outflows (expenses and losses) over a period of time. There are a number of general methods for determining your income. The most basic is the transaction approach, which compares the amounts used in revenue expenses, gains and losses. This method requires a clear definition of when the income elements should be recognized or recorded in the financial statement. In other words, you must know beforehand when your company will gain net assets and when to list them on your statement to attain the most beneficial use of those assets. Other methods include:


Under the generally accepted accounting principle of accrual, revenue recognition does not necessarily occur when cash is received. Generally, service organizations, such as accounting firms, use the cash basis of accounting and only recognize income when they are paid by a client (not when the client was billed). On the other hand, the recognition of a sale for businesses that sell products and carry inventory occurs when the product is sold, not when payment is received.


In order to determine your income, you must establish criteria for revenue recognition, and the principles for recognizing expenses and losses must be clearly defined. Some expenses are directly associated with revenues. These expenses can be recognized in the same period as the related revenues. Other expenses are not associated with specific revenues. These expenses are recognized in the time period when they are paid or incurred. Still, other expenses are not recognized currently as expenses because they relate to future revenues; therefore, these expenses are reported as assets.

5. Cost of Goods Sold

Whether you're a merchandising or manufacturing enterprise, you must determine the cost of goods relating to sales for the period. This is the sum of your beginning inventory, net purchases, and all other buying, freight and storage costs relating to the acquisition of goods. Your net purchases balance is developed by subtracting purchase returns and allowances and purchase discounts from gross purchases. Your cost of sold goods can then be calculated by subtracting your ending inventory from your cost of goods available for sale. When you manufacture your goods, additional elements enter into the cost. Aside from material costs, you will incur labor and overhead costs to convert raw material to a finished good. A manufacturing company has three inventories rather than one: raw materials, goods in process, and finished goods.

6. Operating Expenses

Operating expenses may be reported in two parts -- selling expenses as well as general and administrative expenses. Your selling expenses include items, such as sales salaries and commissions, as well as related payroll taxes, advertising and store displays, store supplies used, depreciation of store furniture and equipment and delivery expenses. Your general and administrative expenses include officers' and office salaries as well as related payroll taxes, office supplies used, depreciation of office furniture and fixtures, telephone, postage, business licenses and fees, legal and accounting services and contributions.

Note: For manufacturing companies, charges related jointly to both production and administrative functions should be allocated in some equitable manner between manufacturing overhead and operating expenses.

7. Other Revenues and Gains

This section usually includes items identified with the peripheral activities of your company. Examples include revenue from financial activities (i.e., rents, interest and dividends) and gains from the sale of assets (i.e., equipment or investments).

8. Other Expenses and Losses

This section parallels other revenues and gains; however, the items result in deductions from, rather than increases to, your operating income. Examples include interest expense and losses from the sale of assets.


American Association of Certified Public Accountants, (AICPA), 1211 Avenue of the Americas, New York, N.Y.