Balance Sheets and Income Statements

The two basic financial statements in a business are the Balance Sheet and the Income Statement.

The Balance Sheet shows the assets of the company on the left (what the company has, or debits.) It is then balanced on the right, by the other side of the story (where the company got the money, or credits.)

Assets are usually things like cash, money owing to us, and inventory which we call current assets. Then we have fixed assets, like buildings and leasehold improvements which we expect to last for more than a year. Assets are listed in order of liquidity or how quickly they can be turned into cash. Cash is obviously the most liquid while long term assets like leasehold improvements are the least.

On the right hand side of the balance sheet there are really only three places a company can get money. They can borrow the money called Liabilities, they can invest their own money called Owner’s Equity or the company can make a profit, and rather than paying the profit out as Dividends to the owners, they can decide to keep the money in the business. This source of money is called Retained Earnings.

A balance sheet is always shown frozen in an instance of time. It is like taking a snapshot picture of the company. For this reason, a balance sheet is always shown as of a particular day, usually December, 31.

An Income Statement on the other hand, is over a period of time and shows the Revenues, or monies coming into the business from its normal activities such as patient visits or supplement sales. Then the Expenses incurred over the same period are deducted in order to determine profit (a plus figure) or loss (a minus figure.)

Revenues, by the way, are credits (where we got the money) and expenses are debits (what we did with the money.) The annual profit (credit) is moved to the right hand side of the balance sheet so that everything balances, and we call it retained earnings. (Profits or earnings retained in the business.) This account will hopefully grow year after year.

Income statements can be produced annually, monthly or even daily. The balance sheet is usually produced on the last day of the income statement. Remember it is the “snapshot” of the company on a single day.

Profits …not a dirty word
Some people feel that profits are bad, or profits made by oil companies are bad, or “large” profits are bad. Nothing could be further from the truth, so long as the profits are made legally in a competitive market.
Let’s look at the role of profits:

1. Profits provide feedback to the company and the public that they are doing something right and that consumers value their products or services.
2. Profits provide the company with money to grow and to provide these valuable services to more people. A company not making a profit will eventually be out of business.
3. Profits encourage others to get into the same business which will bring down prices to the consumer, and will eventually reduce “large” profits.
4. Profits provide social goods because they are taxed by the government in the form of company taxes or personal taxes on dividends. All companies are owned by someone, so all corporate taxes are eventually taxes on people.

A Sample Income Statement and Balance Sheet
A simplified set of financial statements is shown below:

Red Apple Naturopathic Clinic
Income Statement
For the year ended December 31, 20x1

Revenue from patient services	240,000
Revenue from supplement sales	30,000
Total revenue		270,000
Less expenses
Reception staff	24,000
Cost of goods sold (supplements)	25,000
Supplies	3,000
Rent	36,000
Utilities (heat, light and business taxes)	9,600
Amortization of leasehold improvements	20,000
Total expenses		117,600
Net profit before drawings and taxes		152,400
Less taxes (assume 40%)		60,960
Less Owner’s drawings (assume 6,000/mo.)		72,000
Retained earnings (profit left in the business)		19,440

Red Apple Naturopathic Clinic
Balance Sheet
As of December 31, 20x1

Current assets		Current liabilities
Cash	13,120	Accounts payable	3,000
Accounts receivable	4,320	Current portion -bank loan	10,000
Inventory	25,000
Total current assets	42,440
		Long term liabilities
Long term assets		Bank loan	40,000
Leasehold improvements	100,000
Less accumulated amortization	(20,000)	Owner’s equity
Net leasehold improvements	80,000	Owner’s investment	50,000
		Retained earnings	19,440
	122,440		122,440

Amortization Explained
Red Apple Clinic has two sources of revenue, from its patients and sales of supplements. These total a respectable $270,000 for last year. Obviously the clinic owner doesn’t get to keep all of this, for there are a number of expenses to be paid. Most of them like staff and rent which are paid in cash are pretty obvious. An example of a journal entry in this case would be:

Date	Description	Debit	Credit
Mar. 15, 20x1	Salary Expense	1,000
	Cash		1,000
Paid salary to receptionist for 2 weeks

There is a special expense Amortization of leasehold improvements which needs some explanation.
The clinic spent at the beginning of the year, 100,000 on leasehold improvements. We will assume that the clinic borrowed half of this money and that the owner put in the other half from savings. Because these improvements will last more than one year, this expenditure will be recorded as an asset. The journal entry will look like this:

Date	Description	Debit	Credit
January 2, 20x1	Leasehold improvements	100,000
	Owner’s investment		50,000
	Bank loan		50,000
Leasehold improvements on rental property

At the end of the year some of these “improvements” will be “used up” so in order to match revenues and expenses to the same time period we will “write off” some of this asset by depreciating it or amortizing it. (Accountants like to use lots of fancy terms.)

The journal entry will be:

Date	Description	Debit	Credit
Dec. 31, 20x1	Amortization of leasehold improvements	20,000
	Leasehold improvements		20,000
Expensed 20% of leasehold improvements on rental property

Amortization of leasehold improvements is an expense which is debited, and the asset account, leasehold improvements, is reduced by crediting it. (An increase in an asset is a debit, a decrease is a credit.)

An interesting thing about amortization expense is that we do not have to pay cash for this expense. (The cash was already paid out when we purchased the asset.) For this reason it is an expense we like because it will reduce our income for tax purposes, but not cost us any cash. Assuming that all our revenues and all our other expenses were in cash, the business will actually generate 19,440 + 20,000 or 39,440 in cash for the year. (This amount of cash doesn’t automatically show on the balance sheet because we used quite a lot of our cash to purchase additional inventory of supplements. Some cash is also tied up in accounts receivable.) It is good to remember that profits are not always represented by cash, and that sometimes cash generated can be greater than profits.