Understanding Balance Sheets and P&L Statements
Article Last Updated: 28 January 2021
Although the terms "Balance Sheets" and "Profit and Loss (P&L) Statements" can sound intimidating, the truth is that these financial statements can be integral to helping you understand what a company's report is really telling you.
There are significant differences between a balance sheet and a P&L, with important impacts on your investment choices.
What is a Balance Sheet?
A balance sheet (also known as a "statement of financial position") effectively details a company’s assets, its liabilities, and its shareholders' equity at a point in time. This information is critical for understanding how strong the company is in its foundations.
The first column on a balance sheet is often a company's assets. An asset is simply a resource that a company owns that has monetary value. Examples include cash in the bank, short term investments, stocks, trade debt, property, and even petty cash. There are also asset classes such as current assets (those expected to be converted to cash within a year), fixed assets, and intangible assets.
In the other column, you’ll find liabilities. These are debts or payments that a company will expect to pay out in the future. Current liabilities, for example, are those due for payment within a year. Examples include overdrafts, short term loans, and creditors. There are also long term liabilities such as long-term loans, secured bills, directors loans, residual value on leases, and more.
Another important piece of information is shareholder equity. This is the remaining amount of assets available to shareholders when the liabilities have been paid off. There are four components included in shareholder equity: outstanding shares, additional paid-in capital, retained earnings, and treasury stock.
Assets minus liabilities equals shareholder equity. When you know the shareholder equity in a company, you can determine important answers to various questions such as: How much cash do they have available after they have paid all their liabilities? How long can they last if their debts become due? etc.
What is a Profit and Loss (P&L) Statement?
The Profit and Loss (P&L) statement is a crucial piece of the puzzle when understanding the financial strength of a company. This statement is not to be confused as being part of the balance sheet.
The P&L statement (also known as an "income statement", or "statement of financial performance") is a summary of all the revenues, costs, and expenses that have been incurred during a specific time. Normally a P&L statement is calculated per quarter as well as annually.
Top and Bottom Line
One of the common terms you'll hear concerning a P&L statement is the "top line" and "bottom line". The top line essentially refers to a company’s revenues or gross sales. The bottom line is the company’s net income. Everything in between is the company's operating costs and expenses. A healthy top line is one thing, but the bottom line will demonstrate a company's profitability.
Revenues and expenses
The revenues consist of cash inflows or money going into the company. Expenses are cash outflow, or money going out of the company.
What are financial ratios?
A financial ratio helps investors analyse and compare the financial relationship between the statements and accounts within a company.
These types include liquidity ratio, efficiency ratio, solvency ratio, coverage ratio, profitability ratio, and market value ratio. As you can imagine, if a ratio fits a certain amount, you can determine whether this company is a suitable investment.
Think of financial ratios as like a dashboard on a car. You can see the key vitals behind the car and hence you’ll be able to keep your finger on the pulse when it comes to investing in the right company.
Market ratios are an indication of whether a company’s share price is overpriced or under priced. These ratios help the investor determine whether the investment is a worthy one or not, and can hint at the likely direction of the share price in the future.
Liquidity ratios are another financial ratio that enables the investor to determine if debts can be paid off. The reason why liquidity ratios are important is that if a company is unable to pay off its debts, then it is vulnerable to any disaster that may affect it financially.
However, if a company’s liquidity ratio is healthy, then it has enough money to cover its expenses if it can’t produce any revenue for a period of time.
The profitability ratio enables the investor to determine if a business is generating profit at an efficient level. If a company has a strong source of income or multiple sources, then it will likely have a strong profitability ratio. The higher the profitability ratio, the more favourable the company is.
Balance Sheet vs. P&L Statement / Bottom Line
The balance sheet of a company gives you a good understanding of its overall financial health. Hints as to a company's stability and security can be gleaned by using the balance sheet to analyse shareholder equity and liquidity ratios. The P&L statement, and in particular the bottom line, will determine a company's profitability and operating health. Analysing the P&L will give you the market ratios and profitability ratios, which can help you understand the inherent value of the company.
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