Accounting – How does the Balance Sheet relate to Profit and Loss?
For you to get the most important information from the financial statements, you have to comprehend the connection in between the numerous financial statements. However, these correlations are difficult to be identified especially for people don’t have solid accounting background and this is particularly true when the link of different statements is not mentioned in the financial statements as it involved a certain degree of subjectivity. As a result, it depends on you as an entrepreneur to assess these connections, probably by using appropriate financial ratios. Let’s examine how balance sheet and Profit and Loss interact with each other.
Whenever a business transaction is recorded by mean of the double entry accounting (Also see Advantages of double entry accounting), a connection between the two statements can be easily seen. For instance, an increase in purchase will result a decrease in assets or an increase in liability. This is because when a purchase is made by cash, the cash will decrease and the trade creditor will increase if the purchase is made in credit.
This suggests that every business transaction in the Profit and Loss will in a way or another, impact the Balance Sheet. As such, the balance sheet and the Profit and Loss are indivisible despite reported separately for more organised purpose.
Below are more illustrations to demonstrates how the Balance Sheet interacts with Profit and Loss:
- When a cash sale is made (recorded in Profit and Loss), the cash in hand will increase (Balance Sheet item).
- When staff salaries were paid (impacting the Profit and Loss), the cash at bank will reduce (Balance Sheet item).
- When the inventories (in the Balance Sheet) is used up to make a sale, the Cost of sales (in the Profit and Loss) will increase to capture the cost incurred.
- What is left after deducting all the costs from the income will be the net profit (in the Profit and Loss) and this belongs to the shareholders and therefore recorded as Retained earnings in the Balance Sheet.
In spike of the links demonstrated above, the Balance Sheet and Profit and Loss serve a very different purpose. While the Profit and Loss meant to compute the profit earned or loss suffered, the Balance Sheet aims to provide an overview of what the assets, liabilities and equity are at a certain point of time.
Understanding how two statements relates will offer more advance insight that can be valuable to a business owner or an investor but if this is not something you can manage, you try to get an accounting firm Johor Bahru.