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Balance sheet and income statement relationship – Transcript
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- The balance sheet provides an overview of a company’s assets and liabilities at a specific point in time.
- The income statement shows how much a company has earned during a given period through revenue and expenses.
- To make the balance sheet balance, the net income earned during the year is added to equity in retained earnings.
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How do the income statement and balance sheetconnect and interact? Which financial statement is more important:the balance sheet or the income statement? The answer is: both! They each have their own focus and purpose.
This video provides you a deep understandingin less than five minutes. The balance sheet is an overview of a company’sassets and liabilities at a point in time, usually the end of a quarter or the end ofthe year. A balance sheet shows you what a company owns(on the left hand side), and what a company owes (on the right hand side).
As the term “balance sheet” suggests,the total assets should match the total liabilities, what we own equals what we owe. A balance sheet shows you where you got thecapital for the company (on the right), and what you have invested it in (on the left).
The income statement, or profit and loss statement, is an overview of how much a company has earned during a period. Some companies use the terms revenue, expensesand profit. Others use sales, costs, and earnings or income. If your revenue is bigger than your expenses,you make a profit.
If expenses are bigger than revenue, you make a loss. The way to remember these easily is to thinkof the balance sheet as a picture at a point in time, and the income statement as a movieabout a certain period. Let’s put the balance sheet and income statementside by side, starting with a blank sheet.
We will make some simple journal entries toshow the relationship between balance sheet and income statement. If we start a company, we need to raise capital. The certificates of ownership that we giveto shareholders are called equity, and they send us cash.
Our company now owns a cash balance (on theleft), and owes equity to the shareholders. Then we might apply for a loan from the bank. When we sign the loan agreement, we are indebt to the bank. In return, we receive cash.
With the money we raised, we buy Plant andEquipment, in short P&E, or fixed assets. A building and some machines. We now own the Plant and Equipment, and inreturn for getting the keys to the building and the keys to a forklift truck, our cashis reduced.
We order inventory from a supplier. The delivery truck brings you the inventory(another asset, something you now own), and you receive an invoice from your supplierthat you have not paid yet (accounts payable, you owe money to your supplier). So far, we have only touched the balance sheet,growing both what we own and what we owe.
Let’s record some costs or expenses. We receive an interest charge related to thebank loan, and pay it in cash. We account for the usage (value deterioration) of the Plant and Equipment through a depreciation entry.
We record salaries (compensation and benefits) for the staff in our shop, and pay them in cash. Then we finally make our first sale. Note that this took quite a while after startingthe company. For the sales transaction, we record the invoicingof the revenue, and the claim to future cash (accounts receivable) from our customer.
We also record the shipment of the goods tothe customer, and the related Cost of Sales. Then we can calculate subtotals: Gross Profit,Operating Profit (or EBIT Earnings Before Interest and Tax), Profit Before Tax.
We record the tax charge of 20% of the EBT,paying it in cash. And then, to finish off the income statement,we calculate Net Income. Now we seem to have a problem. Our balance sheet does not balance. Our assets are bigger than our liabilities.
What are we missing? This is where we need to remember that thebalance sheet is a picture at a point in time, and the income statement is a movie abouta certain period. We need to somehow connect the picture andthe movie. To do that, we add the net income earned duringthe year to the balance sheet of the end of the year.
Interest is the reward for the bank for grantingus a loan. Net income is the reward for the shareholdersfor making risk-bearing capital available. We add the Net Income earned during the year to Equity, in a sub-account called Retained Earnings. And the balance sheet balances! That’s how the balance sheet and incomestatement fit together. Please subscribe to the Finance StorytellerYouTube channel! Thank you.