In financial accounting , the balance sheet and income statement are the two most important types of financial statements (others being cash flow statement, and the statement of retained earnings). A balance sheet lists assets and liabilities of the organization as of a specific moment in time, i.e. as of a certain date. An income statement — also called a profit and loss account or P&L statement is a report for income and expenses over a specific time period, usually a quarter or year. A company with strong income statements year over year will generally build a healthy balance sheet but it is possible that it may have a strong balance sheet but weak income or vice versa.
Contents
Comparison chart
| Balance Sheet | Income Statement | |
|---|---|---|
| Introduction (from Wikipedia) | In financial accounting, a balance sheet is a summary of the financial balances of a company at a GIVEN point in time. | An income statement is one of the financial statements of a company and shows the company’s revenues and expenses DURING a particular period of time. Answers the question: Is the company profitable? |
| Also known as | Statement of financial position | Profit and loss account ( UK English ); profit and loss statement (P&L); revenue statement; statement of financial performance; earnings statement; operating statement; statement of operations |
| Information it includes | Assets, liabilities, shareholders equity . | Sales , expenses, earnings per share. |
| Time horizon | State of finances at a snapshot in time. | Changes to finances over a particular period. |
What is an income statement?
An income statement shows how a company has performed by listing sales and expenses, and the resulting profit or loss. It also shows earnings per share, which shows how much money shareholders would receive if the company distributed all the net earnings for the period.
Information is typically divided into two sections — operating and non-operating. The operating section lists revenue and expenses from the primary business activities of the company while the non-operating section includes information on other income and expenses, borrowing costs, income tax and some other miscellaneous items.
Cash vs. Accrual Basis
Accounting is usually done via one of two methods — cash or accrual. With cash accounting, revenues and expenses are only counted when cash has been exchanged. For example, if a sale has happened and goods have been delivered to the customer but the customer has not yet paid the bills, the expected amount is not counted as revenue but as an asset under the cash basis, but is counted as revenue under the accrual basis of accounting. So with the cash-based accounting method, the effect of the sale is visible on the balance sheet while under the accrual based method, the sale is reflected in the income statement.
What is a balance sheet?
A balance sheet includes assets, liabilities and equity.
Importance
Income statements report operating results, such as sales and expenses, and so allow investors to evaluate the company’s performance and consider how future cash flows might look. Most investors start by looking at recent income statements when analyzing investment potential . Income statements show profitability on three levels: gross profit , operating profit, and net income, and how profit is being driven (by driving sales, or reducing expenses, for example).
Balance sheets present important information about the financial strength of the company. They allow investors to calculate days of Working Capital, which shows how easily a company can handle changes in revenue while staying afloat. Companies should have at least 30 days of Working Capital, and financially strong companies have more than 180 days. Balance sheets can also identify other trends, such as how the receivables cycle works, how net profits are being used, and how often equipment is replaced.
Misleading Elements
Companies with balance sheets that present the absolute debt level at the half year or year end, but are subject to seasonal debt inflation, may appear stronger financially than they actually are.
Income reports may also have some misleading elements. For example, a company might cut its prices before the end of the quarter to create the illusion of higher sales figures. Products might listed as shipped or received at the end of one year or the beginning of the next, depending on which will create the better figures.
Relationship
Accounting is a “double-entry” system; i.e., every accounting entry has two sides to it, a debit and a credit. For example, a sale recorded on an income statement will increase an asset (such as cash or accounts receivables ) on the balance sheet, and an expense decreases an asset (e.g. cash) or increase a liability (e.g. debt). Sales revenue on an income statement will affect cash and accounts receivable, while cost of goods sold will affect inventory and accounts payable. An income statement for a specific time period can be used to “connect the dots” between the balance sheet at the beginning and end of the period. This video explains how:
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Accounting Tricks
It is possible to use “tricks” to move money around from one statement to the other to make either the income statement or the balance sheet appear healthier. For example, the cash vs accrual method described above. Another example is debt vs. equity. Apple announced in 2013 that it would return billions of dollars to its shareholders via a dividend funded by borrowed money. Normally a dividend would have the following effect:
- On the balance sheet
- the company would see a reduction in assets such as cash or other cash equivalents.
- there would be no increase in liabilities.
- On the income statement
- the company would charge all dividend payments as non-operating expenses.
- A lot of Apple’s cash is parked overseas and repatriating it to the United States would incur a large tax liability (around 35%).
So Apple decided to raise money through a debt offering instead and use it to fund the dividend payout. The effect of this is:
- On the balance sheet, assets stay the same as before but liabilities go up by billions of dollars because of the debt issued.
- On the income statement, in addition to the expenses associated with the dividend Apple now has additional expenses for interest payment on the debt (about 2%). But there is no tax liability.
References
- Beginners’ Guide to Financial Statements – U.S. SEC
- The Importance of Balance Sheets – Fidelity Investments
- Introduction to the Income Statement – Khan Academy on YouTube
- Recent income statements and balance sheets of Google, Inc. – Google Finance
- What is a balance sheet? – MoneyWeekVideos on YouTube
- Why the Balance Sheet Matters – Indiana Small Business Development Center
- Wikipedia: Income statement
- Wikipedia: Balance sheet
