As a small business owner or just someone who occasionally looks at financial statements, it can be daunting to connect the dots between the balance sheet and income statement. But these two tools have much more in common than you might expect.
But what exactly are the differences and similarities, and how do these two reports interact with one another? That's what we hope explain through this in-depth article.
Let's get started.
What is a Balance Sheet?
The balance sheet is a statement of assets (goods that your company owns) and liabilities (debts that your company owes), as well as shareholder’s equity (what the owners have invested). It is a snapshot in time of all these accounts, typically taken at the end of a monthly, quarterly or annual period. The purpose of the balance sheet is to show a company’s net worth at that point in time.
To keep a sense of order, the asset side of the balance sheet must match the liabilities and shareholder’s equity. That is to say, the sum of all entries for what you own must match what you owe. This approach is intuitive when looking at items like inventory (an asset) and short-term debt (a liability), but can become confusing when looking at more obscure entries designed to balance both sides, such as goodwill (an intangible asset).
Balance Sheet Assets
Assets are grouped based on their ease of liquidity in the following order:
- Current Assets
- Property, Plant and Equipment
- Intangible Assets
Current assets consist of items that could be turned into cash the fastest, including cash (duh), short-term investments (bonds, GICs, etc.), accounts receivable (money owed by but not yet received from your customers), inventory, supplies, prepaid expenses and other miscellaneous items.
Investments are mid- to long-term vehicles for parking surplus cash, such as stocks.
Property, Plant and Equipment is exactly as it sounds, including accounts like land, land improvement, buildings, and equipment. Since equipment generally wears down over time, there is a field for depreciation to account for the decline in value. Depreciation is typically calculated based on formulas from government tax services, as it is an expense that reduces overall net income. We see here our first example of how the balance sheet is closely integrated with the (soon to be explained) income statement.
Intangible assets are confusing to novice accounting students, as they consist of assets that don’t physically exist – goodwill and other intangibles. Generally speaking trademarks, logos, brands and IP fall into this category, but technically speaking they get created whenever a company acquires another company and pays an excess over the existing assets. This situation is quite common, particularly when a company:
- is acquiring an older business that has depreciated most of its assets,
- has a strong brand,
- is in the technology space where most of value is tied in intellectual property.
Since a balance sheet always needs to balance, goodwill is created to make things right.
Balance Sheet Liabilities
On the other side of the balance sheet we find liabilities, which as the name suggests are things that the company owes other organizations, including individuals, businesses and governments. Similar to assets, liabilities are grouped by the timeframe for which they come due, and so we end up with short-term liabilities and long-term liabilities.
Included in short-term liabilities are fields such as:
- short term loans payable,
- current portion of long-term debt (the amount that is immediately due or due very soon),
- accounts payable (bills we haven’t yet paid),
- accrued compensation and benefits (money that we will need to pay to employees but haven’t yet),
- income taxes payable.
We also see some oddities, such as deferred revenues, which are payments that a customer has already made before the service or product has been delivered. In this case, since the service has not yet been delivered, the company owes something to the customer (either the service itself or a refund if they cancel). It’s these non-intuitive accounts that lead to big headaches for novice accountants.
Long-term liabilities are longer horizon equivalents of the short-term liabilities, typically due in next financial year or 12 months out. Here we see items like notes (loans) payable, bonds (loans) payable and deferred income taxes.
Balance Sheet Shareholder’s Equity
This section is where all ownership positions within the company are reported. It consists of obvious fields like common stock and additional paid-in capital as well as retained earnings (a summary as all net profit stretching back to the beginning of the company) and Treasury stock (shares that the company has repurchased over time).
How does the balance sheet work?
At its core, a balance sheet is a reflection of how a company has acquired the assets that it currently has, versus the method by which it is financed these assets. The financing can come in the form of liabilities or it can be achieved through equity. Hence the balance sheet formula, assets = liabilities + equity.
There is always a balance between the two halves of the balance sheet (again, duh). Whenever one of the accounts on the asset side increases another account on the same side must decrease, or an account on the liability and equity side must increase.
Viewed in this light, one can see the balance sheet as a working machine where the pulling of one lever automatically causes a change elsewhere.
Because of this constant readjustment to support the fixed relationship, the size of the components of the balance sheet are not nearly as important as ratios between them. For example, a company financed with zero debt and 100% equity will not face the immediate pressure having to pay interest versus a company 100% financed with debt, even though both companies may have exactly the same assets.
Important balance sheet ratios include the following:
- Current ratio - current assets divided by current liabilities
- Quick ratio - cashable assets divided by current liabilities
What is an Income Statement?
While a balance sheet is a snapshot in time of a company’s financial position, an income statement measures changes over a time period, typically one quarter or one year.
The income statement is a cascade of adjustments made against revenue flowing into the company to ultimately come up with net income for the period. It consists of the following (again for the period under consideration):
- Revenue – A total of all recorded sales for the period.
- Cost of Goods Sold (COGS) – Direct product costs associated with these sales.
- Gross Profit – A first approximation of profit looking only at the cost of product inputs (Revenue minus COGS).
- Operating Expenses – Indirect expenses such as salaries, advertising, marketing, etc. Typically Research and Development, Selling, General and Administrative and Depreciation show up as line items here.
- Operating Profit – A second approximation of profit, taking into account the cost of running the operation (Gross profit minus Operating Expenses).
- Other Income/Expenses – Interest (both paid and received) and other income/costs not directly associated with the operations are included here.
- Earnings before Income Taxes (EBIT) – A measure of pre-tax profit, calculated by taking Operating Profit less Other Income/Expenses.
- Taxes – National, State/Provincial and Municipal taxes.
- Net Income – Also known as net profit, this is EBIT minus taxes.
Revenue fuels the income statement, getting picked away by different costs until we come up with the net income for the period. Net income is not the same as cash flow, but rather acts as a measurement of the profit booked for the period under consideration. Collection of cash associated with that profit is often delayed, as seen when a company sends out an invoice with 30-, 60- or 90-day terms. We will discuss the cash flow statement in a separate post.
The income statement is intimately connected to the balance sheet, as it feeds various accounts. For example, retained earnings (the sum total of all profit and loss for all time) is directly affected by net income for the period. More to come on this later.
How does the income statement work?
Imagine a whale at the surface of the ocean dropping dead of a heart attack. This kicks off an event known as whale fall whereby the falling carcass provides nutrients to animals all the way down to the bottom of the ocean. Animals pick at it as they go, with the larger predators taking big bites of blubber at the top, smaller fish grabbing smaller pieces mid-way and the tiniest bone cleaners working the skeleton on the ocean floor.
Thus the nourishing revenue feeds all parts of the company. After it’s been picked clean, we’re left with net income.
The amount of bone-picking is important, as it allows us to understand how much is being left for creatures deeper down. Hence we often look at ratios examining the percentage of picking, including:
- Gross Margin - Gross Profit divided by Revenue
- Operating Margin - Operating Profit divided by Revenue
- Profit Margin - Net Profit divided by (surprise!) Revenue
- Times Interest Earned - EBIT divided by Interest Expense (measures how well you can service debt)
As you can see, many of these ratios are just the cost or net result represented as a percentage of the total revenue, so they measure the size of the bite (or the amount of what is leftover). These are valuable clues to how the company operates as well as a measure of its ongoing operational health.
For example, retailers regularly have high gross profit margins but low profit margins as they consume most of the gross profit to feed real estate leases and expenses. Software companies will often have even higher gross profit margins as they don’t produce physical product.
How the Income Statement and Balance Sheet are connected
Prepare to have your mind blown. Both the income statement and balance sheet are connected to each other. Pow!
Astute observers will notice that there are five unique categories of accounts across the income statement and balance sheet:
Through a methodology known as double-entry bookkeeping, accountants keep strict tabs on each of these accounts. The premise of this system is that every accounting transaction gets matched by an equivalent counter-transaction to balance the system. Hence an increase in revenue must be matched by a counter-transaction, such as a decrease in liabilities. The details of these counteracting transactions are beyond the scope of this article as there are some non-intuitive situations, but suffice to say accounting software generally will take care of this for your organization.
What this all really means is that every time something changes for the business, whether through a sale, purchase, payment or financing, it will cause changes to at least two accounts within the combo-system of income statement and balance sheet. These changes will balance one another, maintaining the direct relationship between the two.
Let’s look again at the income statement, to see how it affects the balance sheet:
- Revenue – Can cause a change in cash and accounts receivable.
- COGS – Will directly affect inventory and accounts payable.
- Operating Expenses – Causes changes in cash and accounts payable, accrued compensation and benefits.
- Depreciation & Amortization – Related to charges taken against fixed and intangible assets for the period.
- Other Income/Expenses – Directly affects cash, short-term and long-term debt, and can also be affected by these accounts.
- Net income – Increases/decreases the total amount of retained earnings.
There are also transactions that occur to the balance sheet outside of the income statement. As before, they require offsetting transactions to balance things out:
- Changing debt levels – Cause corresponding changes in cash.
- Changes to equity – Also cause corresponding changes in cash.
The bottom line, aka Finding a balance
(Sorry, sorry. It just seems that all articles on this topic finish with bad puns.)
As we've seen, both the balance sheet and income statement are critical components in building an understanding of how a business runs. What makes them particularly powerful is their broad adoption, which in turn allowed for development of metrics and ratios that allow for comparison of any two businesses.
However, preparing dashboards to draw comparisions over time periods, or even track different KPIs can be time consuming. To address this challenge, we developed 3AG Finance Insights, a set of pre-built dashboards that connect to all major accounting software packages. To learn more, click on the link below.