In accounting, you often hear the terms ‘balance sheet’ and ‘profit and loss’. These are two closely related financial statements, but they serve different purposes. In this article, I’ll guide you through an example of setting up a small coffee shop.
You invest in an espresso machine, rent a space, and purchase inventory. What goes on the balance sheet, and what goes on the profit and loss statement?
The Balance Sheet: A Snapshot of Assets and Liabilities
The balance sheet provides an overview of your assets (what you own) and how they are financed (liabilities and equity). It is always in balance: everything you own is financed either with your own money (equity) or borrowed money (liabilities).
Example: Coffee Shop Balance Sheet as of January 1st
| Assets (What You Own) | Liabilities (How It’s Financed) |
|---|---|
| €5,000 – Espresso machine | €4,000 – Bank loan |
| €2,000 – Coffee inventory | €4,000 – Own money |
| €1,000 – Cash | |
| Total: €8,000 | Total: €8,000 |
The balance sheet always balances: in this case, you have €8,000 in assets, financed by a €4,000 loan and €4,000 of your own money.
Profit & Loss Statement: Financial Performance Over Time
While the balance sheet is a snapshot, the profit and loss statement (P&L) summarizes income and expenses over a specific period. It shows whether you made a profit or a loss.
Example: Coffee Shop Profit & Loss Statement (January - March)
| Item | Amount (€) |
|---|---|
| Revenue (coffee sales) | 10,000 |
| Cost of purchased coffee | -3,000 |
| Rent | -2,000 |
| Employee salaries | -3,000 |
| Other costs (advertising, utilities, etc.) | -1,000 |
| Profit | 1,000 |
This means that in the first three months, you earned €10,000 from selling coffee. After deducting all costs, you end up with €1,000 in profit.
Connection Between the Balance Sheet and P&L Statement
These two financial statements are strongly connected. The profit you make increases your equity on the balance sheet. Likewise, expenses recorded in the balance sheet also affect the P&L statement.
For example, if you buy an additional espresso machine for €2,000, this impacts:
- The balance sheet: Your assets increase by €2,000, but if you finance it with a loan, your liabilities also increase.
- The profit and loss statement: The purchase itself does not appear directly, but its depreciation (e.g., €400 per year) does.
In April, you decide to expand and rent a second location. This affects both statements:
- On the balance sheet: A new lease contract and additional equipment increase your assets.
- On the profit and loss statement: Your rental expenses rise, but hopefully, so does your revenue.
Common Confusion
Many people confuse profit on the P&L statement with the cash balance on the balance sheet, but making a profit doesn’t necessarily mean you have a lot of cash available. Consider this:
- You sell €5,000 worth of coffee in January, but customers pay in March.
- This revenue counts as income in January (on the P&L statement).
- However, on the balance sheet, it appears as accounts receivable (customers who still need to pay).
This demonstrates that profit and cash in hand are two different things.
Conclusion
To summarize:
- The balance sheet shows what you own and how it is financed at a specific moment in time.
- The profit and loss statement shows how much you earned and spent over a given period.
