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The Connection between the Balance Sheet and the Profit and Loss Statement

The Connection between the Balance Sheet and the Profit and Loss Statement

In order to calculate a company’s annual profit, for example its profit in 2009, the profit and loss statement is not necessary. It can be calculated from the sums appearing in the equity items in two consecutive balance sheets for December 31, 2008 and December 31,2009, as can be seen in the following example, which concerns the USA Chairs company:

USA Chairs’ Balance Sheet as of December 31, 2008 ($)

AssetsLiabilities + Equity
Fixed assets50,000Current liabilities60,000
Current assets50,000Equity40,000

USA Chairs’ Balance Sheet as of December 31, 2009 ($)

AssetsLiabilities + Equity
Fixed assets60,000Current liabilities70,000
Current assets70,000Equity60,000

The calculation is simple:

The net profit in 2009 equals the difference between the equity items for the two years, since the source of the increase in equity from one year to the next is the profit earned by the company during the year.

This assumes that the shareholders neither injected money into the company, nor withdrew a dividend from it (a dividend is a withdrawal from profits).

The profit in 2009 was therefore $20,000 ($60,000 minus $40,000).

Had the company earned no profit during the year, its equity would have remained at $40,000 on December 31, 2009. Had it made a $10,000 loss, its equity would have decreased by $10,000.

If the owners invested money in the company during 2009 (or, in business terms, if the company issued share capital) totaling $10,000, for example, it could be concluded that the increase in its equity originated from two sources:

  1. An increase of $10,000 due to the owners’ injection of money into the company. 
  2. An unknown (at this stage) amount of profit that accumulated during the year. 

The sum of these two sources gives the total increase in equity – $20,000. The accumulated profit during the year is therefore $10,000 ($20,000 minus $10,000).

If it is known that the owners withdrew a $5,000 dividend, it can be deduced that this transaction decreased the company’s equity by $5,000. Since total equity grew by $20,000 during the year, the company’s accumulated profit during the year was $25,000.