Profit & Loss (P&L) and Balance Sheet Explanation
The main purpose of any business, (and some would say the only purpose), is to make a profit. If a business doesn't make a profit, it is just a question of time before it goes down. All businesses sell something, either a product or a service and if the amount of sales they make doesn't exceed the costs involved in producing and selling the product or providing the service, the business is in trouble.
The combination of the Profit and Loss (P&L) statement together with the Balance Sheet is what tells you the actual financial performance.
A business can have plenty of customers but still be going broke and until you see the Profit & Loss statement you just don't know.
The Balance Sheet is the second part of the performance indicator and shows where the Net Profit has actually ‘gone' at any time. It is a ‘snapshot' of the full, financial position of a business at a specific particular day or time.
A Balance Sheet can be confusing, but shouldn't be, and is sometimes used to ‘hide' certain expenses of the business to make the profit picture look better. Look out for expenses such as ‘Repairs & Maintenance' which may be shown as Assets in the Balance Sheet but are really expenses that should be in the P&L.
This means the Net Profit figure in the P&L will be wrong and is not a true record of the company's profitability.
There are three main components of a Balance Sheet: Assets, Liabilities and Owner's Equity.
- Assets are tangible items that a business owns, such as plant & equipment. (P&E)
- Liabilities are what the business owes, such as a loan from a bank.
- Owner's equity is the remainder and is what the owner's investment in the business is worth.
When assessing a business, always insist on seeing figures produced by the owner's accountant, to help ensure the integrity of the P & L and the Balance sheet.