Balance sheets and income statements are two crucial financial statements that provide insights into a company's financial health and performance. This article explores the key differences between these statements, their components, and how different stakeholders in the business can use them together to make informed financial decisions.
Financial statements are an integral part of understanding a company’s financial health and performance. It wouldn’t be a stretch to say that they provide the financial foundation for every business.
Among these, the income statement and balance sheet, though they serve different purposes, stand out. Together, they paint a picture of a company’s financial position and with them, companies can make informed financial decisions.
Think of a balance sheet as a snapshot of a company's assets, liabilities, and equity at a specific point in time. In contrast, an income statement shows the company's revenues, expenses, and profits over a given period.
In this article, we will delve into the differences between balance sheets and income statements, exploring their individual roles and how they complement each other to provide a holistic picture of a company's financial situation.
Understanding balance sheets and income statements
Balance sheets and income statements are two components of the three-statement financial model. The third component is the cash flow statement. Together, these components give a complete view of the company's financial position, performance, and cash flows.
Various stakeholders, like the management team, investors, and creditors, use these statements to make informed decisions that could impact the company’s future.
What is a balance sheet?
A balance sheet captures the financial state of the company at a moment in time as a summary of the company's assets, liabilities, and equity.
It helps stakeholders understand what the company owns and owes, as well as the amount invested by its shareholders at that particular point in time.
The main components of a balance sheet are:
- Assets: These are the resources that the company owns. A key point to highlight is that these ‘resources’ must have an economic value that can potentially provide future benefits. Assets can further be classified as current (short-term) or non-current (long-term).
- Liabilities: Liabilities are the company's financial obligations or debts to other parties. Just like assets, liabilities can be classified as current (short-term) or non-current (long-term).
- Equity: Simply put, equity is a representation of the amount (cash) that would be returned to shareholders if all assets were sold and all liabilities were paid off. Equity is also known as shareholders' equity or net worth.
Using the balance sheet equation, you can see that the company's assets are the sum of its liabilities and equity:
What is an income statement?
An income statement, also known as the profit and loss (P&L) statement, is a report that summarizes a company's financial performance over a specific period, typically a month, quarter, or year.
It drills down to give an exact breakdown of the company's revenues, expenses, and net income (or loss) during the specified time frame.
The primary purpose of an income statement is rather straightforward: to show whether a company is profitable or not. It is an indication of the company's ability to generate profits from its operations, as well as its overall financial robustness and potential for growth.
The main components of an income statement are:
- Revenue: Revenue is the total amount of money the company earns from its primary business activities, such as the sale of products and/or services. Revenues are presented right at the top of the income statement.
- Expenses: These are the cost(s) incurred by the company to generate revenues. Potential expenses include cost of goods sold (COGS), operational expenses such as salaries, rent, utilities, depreciation, and sales and marketing costs, and other expenses such as taxes and interest on debt.
- Net income: This is the remaining profit (or loss) after all expenses are subtracted from the revenue. A positive net income means that the company is profitable, and a negative net income means it’s not.
Net income is the difference between your revenue and expenses:
Here's an example income (aka P&L) statement to illustrate how it is set up.
Balance sheets vs. income statements: Key differences
As we pointed out above, both balance sheets and income statements are essential financial reports, but they serve different purposes by providing distinct information about a company. The table below shows some of the key differences between them.
A balance sheet shows a company's assets on one side and its liabilities and equity on the other. This helps one understand the company's financial position, including its liquidity (its ability to pay short-term obligations) and solvency (its ability to pay long-term debts). With this information, one can determine whether the company has sufficient resources to support its operations and growth.
In contrast, an income statement shows a company's revenues at the top, followed by expenses and net income (or loss), in that order. This allows stakeholders to assess a company's profitability and potential for growth, as well as identify improvement areas.
While each statement provides valuable insights on its own, analyzing them together offers a more comprehensive view of a company's overall financial health and performance.
How are balance sheets and income statements linked?
The flow of financial information between balance sheets and income statements is primarily related to cash and retained earnings. The net income (or loss) reported on the income statement directly affects the balance sheet, either by increasing or decreasing the company's cash position and equity.
Another key connection between the two statements is retained earnings, which is a component of shareholders' equity on the balance sheet.
Retained earnings basically represent the portion of a company's net income that is not distributed to shareholders as dividends but is instead reinvested in the business. At the end of each reporting period (monthly/quarterly), the net income (or loss) from the income statement is added to/subtracted from the retained earnings account on the balance sheet.
Cash flow is another major link between income statements and balance sheets. The net income reported on the income statement represents the difference between revenues and expenses, but it does not necessarily reflect the actual cash inflows and outflows during the period.
Changes in accounts receivable (AR), accounts payable (AP), and inventory can impact cash flow without affecting net income. The cash flow statement, which is derived from both the income statement and balance sheet, provides a better picture of a company's cash position and how it has changed over time.
In practice, balance sheets and income statements are typically produced at the same interval, such as monthly, quarterly, or annually. While the balance sheet focuses on a company's assets, liabilities, and equity at a specific point in time, the income statement primarily concerns the company's day-to-day operations and profitability over a given period.
Investors often place greater emphasis on the income statement when assessing a company's short-term performance and making financial projections.
Importance of balance sheets and income statements for investors, creditors, and company leaders
Balance sheets and income statements are essential because they provide valuable information for various groups, such as investors, creditors, and management. Each stakeholder group makes informed decisions based on its specific interests and objectives.
- Investors: Investors usually have a long-term focus and rely on both balance sheets and income statements to assess a company's health. The income statement, if plotted on a graph, gives the investor a pulse of the company's operations and profitability.
The balance sheet gives a view into the current financial health of the business, helping them assess its liquidity, solvency, and overall financial stability.
Investors also use financial ratios derived from balance sheets and income statements to compare a company's performance to its peers and industry benchmarks.
- Creditors: Creditors, such as banks and bond holders, use balance sheets and income statements to assess a company's credit worthiness and ability to meet its debt obligations.
The balance sheet provides information about a company's assets, liabilities, and equity, allowing creditors to evaluate the company's financial leverage and collateral.
The income statement helps creditors assess a company's ability to generate sufficient cash flow to service its debt obligations.
Creditors also use financial ratios based on information from balance sheets and income statements to determine a company's financial risk, helping them make informed decisions about lending, interest rates, and loan covenants.
- Company leaders: The management relies on balance sheets and income statements to make strategic decisions and monitor the company's financial performance.
The income statement is a primary focus for management. This information helps management identify areas for improvement, such as cost reduction or revenue growth opportunities.
The balance sheet helps management make decisions about investments, financing, and working capital management. For example, leadership may use the balance sheet to determine if the company has sufficient assets to invest in new projects or if it needs to raise additional capital.
The company’s leadership also keeps a close tab on its runway, which is the amount of time a company has before it runs out of cash, based on its current cash balance and burn rate. Calculating the runway requires information from both the balance sheet (cash balance) and the income statement (net income or loss).
Strategic decision-making based on both statements
Balance sheets and income statements are useful for external signaling and for a company's internal decision-making process. Below listed are some key areas where balance sheets and income statements inform strategic decision-making:
- Investment decisions: The balance sheet enables leaders to assess the company's financial resources and its ability to invest in new projects, expansion and acquisitions. The income statement helps them evaluate the potential returns on these investments and their impact on the company's profitability.
- Financing decisions: The balance sheet provides information about a company's existing debt and equity structure. Leaders use this information, along with the income statement's insights into cash flow and profitability, to make decisions about raising additional capital, whether through debt or equity financing.
- Policy decisions: The balance sheet also shows the company's retained earnings, while the income statement provides information about the company's net income. This can help the leadership determine the company's dividend policy, which is a balancing act between the need to reward shareholders and the need to reinvest profits back into the business.
- Cost management: The income statement provides detailed information about a company's expenses. Company leaders can use this information to identify areas where costs can be reduced or controlled, improving the company's overall profitability.
- Pricing strategies: Companies can use their gross margin to decide pricing strategies, balancing the need to remain competitive with maintaining sufficient profit margins.
When are balance sheets and income statements required?
- When you need to attract investment: Investors, whether angels or VCs, require balance sheets and income statements to assess a company's financial health and growth potential.
- When it's time to file corporate taxes: Balance sheets and income statements help tax authorities assess a company's tax liabilities and ensure compliance with applicable laws and regulations.
In addition to investors and tax authorities, other parties such as lenders, creditors, and potential business partners may also require balance sheets and income statements to assess a company's financial stability and creditworthiness.
Mastering financial statements for data-driven decision-making
Balance sheets and income statements are two essential financial statements that provide critical insights into a company's financial health and performance.
Using a financial planning and analysis (FP&A) tool like Drivetrain, that directly connects with all the different financial software tools businesses use, especially accounting systems, can significantly streamline the process of creating, analyzing, and sharing accurate financial statements.
You can quickly and easily create accurate financial statements in real time with Drivetrain, allowing you to leverage balance sheets and income statements to their full potential. Explore Drivetrain today to see how y gain a deep understanding of your company’s financial health, make data-driven decisions, and drive long-term success.
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