If you’re seeking low cost funds to grow your business, lenders will ask for a number of financial documents to assess the overall health of your company.
Two documents business owners are frequently asked to produce is an up-to-date balance sheet along with an income statement. Although they seem similar, each document reveals different information to lenders about your business. Here is information about each and why you need to have both on hand when approaching a lender.
What is a Balance Sheet?
According to the SBA, this statement provides an overall financial snapshot of your small business. As an equation, it looks like:
[ASSETS = LIABILITIES + NET WORTH]
- Assets Cash is considered the most liquid of all assets. Long-term assets , such as equipment or real estate, are less likely to be quickly converted into a current asset, such as cash. Current assets are any assets that can be easily converted into cash within a calendar year. Examples of current assets are checking or money market accounts, accounts receivable and notes receivable that are due within that year. Total assets represent the total dollar value of both short-term and long-term assets.
- Liabilities Liabilities include operational costs, debt and material expenses. In general, the lower your liabilities, the greater the value of your business. Current Liabilities may include accounts payable, credit card bills that are due, lines of credit and taxes owed. Fixed Liabilities may include long-term mortgages, car loans and property or building mortgage expenses.
- Net Worth This figure can be computed relatively easily using your company’s liabilities and assets with the above formula – subtracting the total liabilities from the total assets to get the net worth of the business.
What is an Income Statement?
Also known as a “Profit and Loss Statement,” this document measures a company's financial performance over a specific period of time and includes all revenue and expenses.
An income statement shows lenders a company’s ability to generate profit by increasing revenue, reducing costs or both.
For in-depth information about calculating this financial document, review this post on the SmartBiz Small Business Blog: How To Prepare An Income Statement.
The Difference Between an Income Statement and a Balance Sheet
The differences between the balance sheet and income statement are outlined below:
- Timing The balance sheet reveals the status of an organization's financial situation as of a specific point in time, while an income statement reveals the results for a period of time.
- Items Reported The balance sheet reports assets, liabilities, and equity, while the income statement reports revenues and expenses.
- Uses The balance sheet is used to determine whether a business has sufficient liquidity to meet its obligations, while the income statement is used to examine results, and find any operational or finance issues that are in need of correction.
- Performance A key difference between balance sheets and income statements is that only an income statement shows performance. Unlike an income statement, a balance sheet can’t tell you how your business’s actual financial position compares to your projections.
- Reporting Balance sheets and income statements report different data. The former shows information about your assets, liabilities, and equity, while the latter breaks down your operations into revenue and expenses.
- Creditworthiness Balance sheets can help you get more out of credit lines you already have, as your lenders may provide you with more credit if you can show them your bottom line is strong enough to cover it. Income statements matter for acquiring new loans, as lenders need to get a full picture of your operating income and net profit to determine whether you’re an ideal borrower.
How Are They Used?
The balance sheet shows if a business is over-leveraged and can handle additional credit. It can also help potential investors and current shareholders see how much value your company currently has. That’s because a balance sheet shows the assets that your company currently owns and the liabilities that reduce its profits.
The income statement is used to decide whether a business is generating a sufficient profit to pay off liabilities. You can also use it internally to determine whether your company is meeting its financial forecasts for a designated time period and what it means if you’re way off course. Income statements are additionally helpful for identifying areas in which you’re spending too much and planning how to scale back on those fronts.
Which is More Important?
According to Investopedia, the importance of these two reports varies. However, the general view is that the balance sheet is second in importance to the income statement, because the income statement reports the results of the enterprise. Additionally, since lenders and investors are more interested in income statements than balance sheets, income statements may be more important since you can use them to fuel growth.
That said, in certain situations, a balance sheet may be more important. For example, if you want to determine your company’s assets at a specific point in time ahead of a certain purchase, balance statements are more useful. You’ll also have an easier time calculating your debt to equity ratio with a balance sheet.
What Do They Have in Common?
Although balance sheets and income statements mostly serve different purposes, they overlap in small ways. For starters, they’re each considered one of the three major financial statements (the third is the cash flow statement ). Additionally, you’ll probably want to have both on hand when applying for loans, speaking with investors, or conducting internal reviews.
How to Prepare an Income Statement
To prepare an income statement, take the following steps:
- Determine your trial balance.
- Tally all your revenue line items and write the value as your income statement’s revenue line item.
- Tally all your cost of goods sold (COGS) line items and write the value as your income statement’s COGS line item. This line item should appear directly below your revenue line item.
- Subtract your COGS sum from your revenue sum to get your gross margin. Record this as another line item.
- Tally all your selling, general, and administrative expenses and record your sum as a line item.
- Determine your interest, depreciation, and amortization, then record your sum as a line item.
- Subtract the expenses in steps five and six from your gross margin to get your pre-tax income. Record this value as another line item near the bottom of your income statement.
- Use the corporate tax rate (or a different tax rate if your company does not pay corporate taxes) to calculate your income tax. Record this value as a line item below your pre-tax income.
- Subtract your taxes from your pre-tax income to get your net income. This should be the very bottom line of your income statement.
- Add your company’s name and the period in question to the top of your profit and loss statement.
Income statement example
An income statement that follows the above steps might look like this:
Your Business Name
Income Statement for Q1 2021
How to Prepare a Balance Sheet
To prepare a balance sheet, take the following steps:
- Record your current cash balance.
- Record your marketable securities.
- Record your accounts receivable balance.
- Record your inventory.
- Record your fixed assets.
- Sum the above items and record the total as your total assets.
- Record your total usual bills.
- Record your accounts payable.
- Record your wages payable.
- Record your taxes.
- Record your loans.
- Sum the above items and record the total as your total liabilities.
- Record your owner’s equity.
- Create a final line item for the sum of your total liabilities and your owner’s equity. This number should be equal to the sum of your total assets.
Balance sheet example
If you follow the above steps, your balance sheet should appear as follows:
Your Business Name
It’s important to have a firm grasp on both of these financial statements when you begin the loan application process. Look to your accountant or another financial professional to help pull together the numbers if you need help in this area. Be sure to have both of these documents up-to-date so you can easily upload and share with lenders.