Exercise: Linking Income Statements to Balance Sheets

by March 28, 2016

Here are a few insightful financial analysis questions you could ask about the links between our fictional ABC Corp.’s income statement and balance sheet and how they are linked:

  1. ABC Corp. will obviously be buying and selling many widgets. If it buys lots of inventory, but then cannot sell the widgets, a simple comparison of Sales Revenue to ABC Corp. managers’ Sales Projections will highlight a potential problem. At the same time Inventory will be higher than expected on the balance sheet.
  2. What if ABC Corp. is forced to sell widgets at a price less than $5? A simple comparison of Sales Revenue to Cost of Goods Sold will highlight whether ABC Corp. can sell widgets at an acceptable price. Perhaps that competition forces ABC Corp. to lower prices or, ABC Corp.’s customers demand fewer widgets, causing ABC Corp. to lower prices. However, if ABC Corp. is slow (or refuses to lower prices) Inventory will be higher than expected on the balance sheet.
  3. What if the wholesale price of widgets increases from $4 to, say $4.25? Can ABC Corp. pass on this price increase to its customers or does ABC Corp.’s net income decrease? Again, simply comparing Sales Revenue to Cost of Goods Sold will highlight whether ABC Corp. can sell widgets at an acceptable price. If it tries to pass on the full cost but customers refuse to pay it, Inventory will be higher than expected on the balance sheet.
  4. What if ABC Corp’s customers are less able, or unwilling, to pay? Or, what if ABC Corp. starts selling to low credit quality customers? Then, the Accounts Receivable balance will grow disproportionately to Sales Revenue.
  5. What if ABC Corp. is less able or is unwilling to pay for its Inventory? Then Accounts Payable will grow disproportionately to Inventory.

Studying these questions helps illustrate that you can potentially learn more about ABC Corp.’s economic activities surrounding its purchases and sales of widgets by analyzing both its income statement and balance sheet while considering the links between the two.