Relationship between balance sheet and income statement

Connection between Balance Sheet and Income Statement

The connection between the balance sheet and the income statement results from:

• The use of double-entry accounting or bookkeeping, and
• The accounting equation Assets = Liabilities + Owner's Equity

Basically, the income statement components have the following effects on owner's equity:

• Revenues and gains cause owner's (or stockholders') equity to increase
• Expenses and losses cause owner's (or stockholders') equity to decrease

Example of How the Balance Sheet and Income Statement Are Connected

To illustrate the connection between the balance sheet and income statement, let's assume that a company's owner's equity was $40,000 at the beginning of the year, and it was $65,000 at the end of the year. Let's also assume that the owner did not invest or withdraw business assets during the year. Therefore, the $25,000 increase in owner's equity is likely the company's net income earned for the year. The details for the $25,000 (revenues, expenses, gains, losses) will be reported on the company's income statement for the year.

Accountants refer to the income statement accounts (revenues, expenses, gains, losses) as temporary accounts because their balances will be closed and transferred to the owner's capital account at the end of the year.

The balance sheet and income statement are both important documents to business owners everywhere. When a company has a strong income statement it will usually have a good balance sheet, but it is possible for one of them to be weak while the other is strong. You may now be asking yourself what makes this happen—what makes them different? In the balance sheet versus income statement fight, who wins?

We can see the difference in what exactly each one reports. The income statement gives your company a picture of what the business performance has been during a given period, while the balance sheet gives you a snapshot of the company’s assets and liabilities at a specific point in time. That is just one difference, so let’s see what else makes these fundamental reports different.

What is a Balance Sheet?

The balance sheet is a snapshot of what the company both owns and owes at a specific period in time. It’s used alongside other important financial documents such as the statement of cash flows or income statement to perform financial analysis. The purpose of a balance sheet is to show your company’s net worth at a given time and to give interested parties an insight into the company’s financial position. 

What Is Included in a Balance Sheet? 

The balance sheet is a financial statement comprised of assets, liabilities, and equity at the end of an accounting period. 

• Assets include cash, inventory, and property. These items are typically placed in order of liquidity, meaning the assets that can be most easily converted into cash are placed at the top of the list. 
• Liabilities are a company’s financial debts or obligations. They include things such as taxes, loans, wages, accounts payable, etc. 
• Equity is the amount of money originally invested in the company, as well as retained earnings minus any distributions made to owners.

The foundation of the balance sheet lies in the accounting equation where assets, on one side, equal equity plus liabilities, on the other. 

The formula is intuitive: a company has to pay for everything it owns (assets) by either taking out a loan (liability), taking it from an investor (issuing shareholders’ equity) or taking it from retained earnings.

For example, if a company takes out a 5 year, $6,000 loan from the bank not only will its liabilities increase by $6,000, but so will its assets. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders’ equity. 

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The company’s total assets need to equal total liabilities plus equity for the balance sheet to be considered “balanced.”

The balance sheet shows how a company puts its assets to work and how those assets are financed based on the liabilities section. Since banks and investors analyze a company’s balance sheet to see how a company is using its resources, it’s important to make sure you are updating them every month. 

What Is an Income Statement?

The income statement, often called a profit and loss statement, shows a company’s financial health over a specified time period. It also provides a company with valuable information about revenue, sales, and expenses. These statements are used to make important financial decisions. 

Both revenue and expenses are closely monitored since they are important in keeping costs under control while increasing revenue. For example, a company’s revenue could be growing, but if expenses are growing faster than revenue, then the company could lose profit.

Usually, investors and lenders pay close attention to the operating section of the income statement to indicate whether or not a company is generating a profit or loss for the period. Not only does it provide valuable information, but it also shows the efficiency of the company’s management and its performance compared to industry peers.

What’s Included in an Income Statement?

Income statements include revenue, costs of goods sold, and operating expenses, along with the resulting net income or loss for that period. 

An operating expense is an expense that a business regularly incurs such as payroll, rent, and non-capitalized equipment. A non-operating expense is unrelated to the main business operations such as depreciation or interest charges. Similarly, operating revenue is revenue generated from primary business activities while non-operating revenue is revenue not relating to core business activities. 

Balance Sheet vs Income Statement: The Key Differences

It is important to note all of the differences between the income and balance statements so that a company can know what to look for in each. 

• Timing: The balance sheet shows what a company owns (assets) and owes (liabilities) at a specific moment in time, while the income statement shows total revenues and expenses for a period of time. 
• Performance: The balance sheet doesn’t show performance—that’s what the income statement is for.
• Reporting: The balance sheet reports assets, liabilities, and equity, while the income statement reports revenue and expenses.
• Usage: The company uses the balance sheet to determine if the company has enough assets to meet financial obligations. The income statement is used to evaluate performance and to see if there are any financial issues that need correcting.
• Creditworthiness: Lenders use the balance sheet to see if they should extend any more credit, but they use the income statement to decide on whether or not the business is making enough profit to pay its liabilities. 

Do They Have Anything in Common?

Although the income statement and balance sheet have many differences, there are a couple of key things they have in common. Along with the cash flow statement, they make up three major financial statements. And even though they are used in different ways, they are both used by creditors and investors when deciding on whether or not to be involved with the company. 

While we can conclude that the income statement and balance sheet are used to evaluate different information, we can agree that both statements play important roles to banks and investors because they provide a good indication on the current and future financial health of a company.

Want to dig a little deeper to understand how to read each of these reports? Check out our blog post, A Complete Guide to Reading Financial Statements.

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