Do you ever have a song stuck in your head? Right now I have one I can’t get out. It’s not a bad song mind you. In fact, it goes with the topic I sat down to write about today, which is probably why it is stuck in my head. What song could possible go with an accounting blog you might ask? Well, it’s “Love and Marriage” by Frank Sinatra of course. “Love and marriage, love and marriage. Goes together like a horse and carriage……you can’t have one without the other!” Are you singing it now too?
It’s that last line, “you can’t have one without the other” that made it stick in my head. You see lately we have been seeing some confusion over how to use the Balance Sheet and P&L statement to accurately gauge the financial health of your organization. Some business owners rely too heavily on just the P&L. They think that, so long as the Profit & Loss shows a positive number that they should have that same number in the bank. That is not the case. To understand the unique partnership a Balance Sheet and P&L share, you have to understand what part each plays.
First some basics. The Balance Sheet includes the assets, liabilities and capital of the organization at a particular point in time. It is the “snapshot” of not only what a business owns but also what it owes at a particular time. The Profit & Loss (P&L) reports the organizations financial performance over a specific period of time by giving a summary of revenues and expenses. The end result is the either net profit or loss.
You might think that just looking at the P&L is enough to know exactly how healthy your finances are, but it isn’t. You have to use both the Balance Sheet and P&L together. Why? Look back up a few lines and notice how the words “owns” and “owes” are emphasized. That is the “why”.
Say your business takes out a loan. As we know, when you go to start paying back that loan, there will be two parts. Principal and interest. Only the interest payment will show up as expenses being paid out on your P&L, not the entire payment. However, on your balance sheet, you will see your long term debt represented underneath your liabilities column. In order for you to have a complete financial picture of your organization, you must use both the P&L and the Balance sheet. Knowing what you will have to spend in the future is just as important as knowing what you have today.
Let’s look at it another way. In some businesses that operate with client retainers, such as law practices, certain accounts that need to be monitored only appear on the balance sheet and not the P&L.
So what does that look like in real life? A law practice that accepts retainers from clients should have an IOLTA Bank Account and a Client Trust Liability (or Retainer Funds) liability account that match to the penny. To the layman, these are the funds that have been set aside for the law firm to be paid for services rendered, but that have not yet been earned. Both of these accounts are held on the balance sheet. If that law practice were to only review the P&L, they would not know if these accounts are being handled properly.
And lastly, as many of you may know, investors ask for both of these documents when they are evaluating a company. They know that both of these statements are necessary to properly scrutinize a company’s financial health. If the people whose main job is to evaluate and determine the worth of an organization uses these documents, how much more important is it for you as a business owner, to understand their unique dynamic.
If you would like even more information on this topic, I suggest visiting http://www.investopedia.com/ask/answers/121514/what-difference-between-pl-statement-and-balance-sheet.asp. Not only is the article helpful, but the video is great too.
So this next month as you are generating your Balance Sheet and P&L, remember “you can’t have one without the other”. And sorry if you can’t get the song out of your head either.