This is the third of a series of articles focused on financial accounting disclosures and how you, as a journalist, can interpret and report on them. If you have a topic you are interested in, post your request in the comments or email me at email@example.com.
Understanding the link between balance sheets and income statements is the bedrock fundamental from which to analyze financial statements. But the idea is complicated. As such, a reasonable learning goal for this article is familiarity with the topic. Future articles, focused on real-world events and examples, will reinforce your understanding.
Developing an understanding of the links between income statements and balance sheets
We highlighted in previous articles that financial accounting measures wealth (the balance sheet) and wealth created (the income statement), and does so conservatively. This week we’ll link income statements and balance sheets. Important economic events affect a firm’s balance sheet and income statement simultaneously. Assessing these economic events, from both balance sheet and income statement perspectives, will almost always help you ask insightful questions about firms’ financial performances.
By tradition, financial accounting measures wealth created for shareholders. For any firm:
Figure 1 is a mathematical tautology. To extend it a bit, if shareholder wealth is destroyed (instead of created) then the amount destroyed is subtracted (instead of added). Shareholder wealth distributions occur frequently and include both dividends to shareholders and firms’ purchases of their own shares, which also distribute wealth to shareholders.
Given that the income statement records net earnings as wealth created (for shareholders), we can then rewrite Figure 1 in terms of financial accounting terminology:
From Figure 2, net income from the income statement increases Shareholders’ Equity. The balance sheet is linked to the income statement because the balance sheet equation is Assets equals Liabilities plus Shareholders’ Equity, or A = L + SE. Observe that A = L + SE is equal to A – L = SE. This means that when a firm earns say, $10 of net income, SE will increase by $10 (refer to Figure 2) and for A – L = SE then A – L must also increase by $10. In other words, the income statement and balance sheet are linked. Whenever wealth inflows or outflows are recorded on the income statement, affecting Shareholders’ Equity, those inflows and outflows also affect Assets less Liabilities.
Understanding how an income statement and balance sheet are linked helps when analyzing financial statements. Let’s explore this idea in detail.
Financial statement effects of buying and selling inventory
Suppose a firm, ABC Corp., buys fictional ‘widgets’ from a manufacturer and then sells the widgets to retailers. What we are interested in initially is how much wealth a firm creates in this process. To answer this question, let’s focus on a single widget that the firm buys from the manufacturer for $4 and sells to a retailer for $5. The wealth created is $1. Now trace these two economic events (buying and selling the widget) through the financial statements in order to ask financial statement analysis questions.
When ABC Corp. buys the widget, it records an asset, Inventory, for $4. Assume ABC Corp. agrees to pay the manufacturer in the future, then ABC Corp. also has a liability, Accounts Payable, for $4. As we know, A = L + SE. In this transaction, assets increase by $4 as do liabilities, so the balance sheet equation still balances. Shareholders’ Equity does not change, and no wealth is created (or destroyed) with this economic event.
When ABC Corp. sells the widget to a retailer it records Sales Revenue of $5 on the income statement. This is a wealth inflow. But at the same time the widget has been sold, so Cost of Goods Sold, a wealth outflow of $4, is recorded on the income statement. The income statement documents net earnings of $5 less $4 equals $1. This means that SE increases by $1 and must also mean that A – L increases by $1. Let’s explore how.
When the widget is sold, ABC Corp. either receives cash (an asset) of $5, or, more likely, an IOU from its customer for $5. The IOU is termed an Accounts Receivable. Either way, assets increase by $5. But ABC Corp. transfers ownership of the widget to its customer, implying that another asset, Inventory, decreases by the cost of the widget, which is $4. Overall Accounts Receivable increases by $5 and Inventory decreases by $4, or assets increase by $1. Assets equal Liabilities plus Shareholders’ Equity (A = L + SE). Since assets increase by $5 less $4 and this equals $1, Shareholders’ Equity increases by $1.
The net result of these economic events is that ABC Corp. has increased its Shareholders’ Equity by $1 because it generated net income of $1 and it now has $1 more in assets. The balance sheet balances (A = L + SE). More important, the income statement is linked with the balance sheet. Understanding this concept is vital to analyzing firms, particularly when they engage in more complicated economic events than those in our widget example.
Financial analysis questions to ask
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:
- 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.
- 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.
- 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.
- 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.
- 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.
As mentioned, many first view the concepts explored in this article as complex, but these ideas are necessary for you to insightfully analyze financial statements to develop questions and comments about firms’ financial performances. Again, a reasonable learning goal for this article is familiarity, not a full understanding.
We will start analyzing real world financial statement issues. In doing so, we will utilize the above concepts, which will help reinforce your understanding of them.
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