How to read a balance sheet and a profit and loss statement

The balance sheet and the profit and loss statement are two basic views of how a company is performing. Once you learn to read the balance sheet and the profit and loss statement, you get a quick picture of how the company is doing and where it has room for improvement.

What the balance sheet shows

The balance sheet is a snapshot of assets and their sources as at a particular date. On one side you see what the company owns, on the other how it is financed, i.e. from its own or external funds.

Both sides of the balance sheet are always equal, because every asset has its source. This balance is the basic principle of double-entry bookkeeping.

• assets – the company’s property
• equity – the owners’ funds
• liabilities – external sources of financing

What the profit and loss statement shows

The profit and loss statement records expenses and revenue for a given period, and the difference between them is the profit or loss. Unlike the balance sheet, it is not a position as at a single date, but a flow over the whole period.

This is exactly where you see whether the company is making money or making a loss, where its revenue comes from and where its expenses go.

How the statements are related

The two statements are interlinked. The profit or loss from the profit and loss statement is reflected in equity on the balance sheet.

That is why it pays to read them together, not separately. The profit figure on its own, without the context of the balance sheet, does not tell the whole story about the company’s health.

What to focus on

When reading, look not only at the absolute figures but also at the relationships between them. A comparison with the previous period will show the trend, which is often more important than a single figure in one year.

• the ratio of own funds to external funds
• how sales and expenses develop over time
• the ability to cover liabilities with assets

Practical use

Reading the statements regularly helps to uncover problems before they deepen, for example growing liabilities or a falling margin.

If you are unsure how to interpret them, go through the statements with an accountant, who will show you the connections behind the figures and help you draw the right conclusions for managing the company.

Useful indicators

From the balance sheet and the profit and loss statement you can derive simple indicators that quickly tell you about the health of the company. You do not have to be an analyst to understand them.

You can track, for example, profitability, i.e. what share of sales remains as profit, or indebtedness, which shows the extent of financing by external funds. These ratios say more than the absolute figures on their own.

• return on sales as the share of profit in revenue
• indebtedness as the proportion of external funds
• liquidity as the ability to pay liabilities

Common misconceptions when reading the statements

A common mistake is to judge a company only by its profit and ignore the balance sheet. A company can report a profit and still have cash problems if its customers do not pay on time.

That is why it pays to read the statements together and in context. A true picture of the company only emerges when you combine the view of assets, liabilities and the flow of expenses and revenue.

How to benefit from the statements in practice

Being able to read the balance sheet and the profit and loss statement is not just theory. It helps an entrepreneur decide whether they can afford an investment, whether the company has a sufficient reserve and where profit is needlessly leaking away.

It is advisable to go through the statements at least once a quarter, not just once a year when the accounts are closed. An ongoing overview lets you react in time and make decisions based on figures, not just on gut feeling.

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Frequently asked questions

What is the difference between a balance sheet and a profit and loss statement?

The balance sheet shows the position of assets and their sources as at a particular date, i.e. what the company owns and how it is financed. The profit and loss statement records expenses and revenue for the whole period, and the result is a profit or a loss.

What should I look at first when reading the statements?

Focus on trends over time, i.e. the comparison with the previous period, and on the ratio of own funds to external funds. The trend often tells you more than a single figure. The company’s ability to cover its liabilities with its assets is also important.