Balance sheet and income statement relationship

How do the income statement and balance sheet connect and interact? Which financial statement is more important: the balance sheet or the income statement? The answer is: both! They each have their own focus and purpose. This video provides you a deep understanding in less than five minutes.

⏱️TIMESTAMPS⏱️
00:00 Intro
00:21 What is a balance sheet
00:51 What is an income statement
01:13 Balance sheet and income statement relationship
01:35 Raising capital
02:00 Plant and Equipment (P&E)
02:17 Buying inventory from supplier
02:33 Recording expenses
02:59 Sales transaction
03:19 Profitability
03:40 Retained earnings

The balance sheet is an overview of a company’s assets and liabilities at a point in time, usually the end of a quarter or the end of the year. A balance sheet shows you what a company owns (on the left hand side), and what a company owes (on the right hand side). As the term “balance sheet” suggests, the total assets should match the total liabilities, what we own equals what we owe. A balance sheet shows you where you got the capital for the company (on the right), and what you have invested it in (on the left).

The income statement, or profit and loss statement, is an overview of how much a company has earned during a period. Some companies use the terms revenue, expenses and profit. Others use sales, costs, and earnings or income. If your revenue is bigger than your expenses, you make a profit. If expenses are bigger than revenue, you make a loss.

The way to remember these easily is to think of the balance sheet as a picture at a point in time, and the income statement as a movie about a certain period.

Let’s put the balance sheet and income statement side by side, starting with a blank sheet. We will make some simple journal entries to show the relationship between balance sheet and income statement.

If we start a company, we need to raise capital. The certificates of ownership that we give to shareholders are called equity, and they send us cash. Our company now owns a cash balance (on the left), and owes equity to the shareholders.

Then we might apply for a loan from the bank. When we sign the loan agreement, we are in debt to the bank. In return, we receive cash.

With the money we raised, we buy Plant and Equipment, in short P&E, or fixed assets. A building and some machines. We now own the Plant and Equipment, and in return for getting the keys to the building and the keys to a forklift truck, our cash is reduced.
We order inventory from a supplier. The delivery truck brings you the inventory (another asset, something you now own), and you receive an invoice from your supplier that you have not paid yet (accounts payable, you owe money to your supplier).

So far, we have only touched the balance sheet, growing both what we own and what we owe. Let’s record some costs or expenses. We receive an interest charge related to the bank loan, and pay it in cash. We account for the usage (value deterioration) of the Plant and Equipment through a depreciation entry. We record salaries (compensation and benefits) for the staff in our shop, and pay them in cash.

Then we finally make our first sale. Note that this took quite a while after starting the company. For the sales transaction, we record the invoicing of the revenue, and the claim to future cash (accounts receivable) from our customer. We also record the shipment of the goods to the customer, and the related Cost of Sales.

Then we can calculate subtotals: Gross Profit, Operating Profit (or EBIT Earnings Before Interest and Tax), Profit Before Tax. We record the tax charge of 20% of the EBT, paying it in cash. And then, to finish off the income statement, we calculate Net Income.
Now we seem to have a problem. Our balance sheet does not balance. Our assets are bigger than our liabilities. What are we missing? This is where we need to remember that the balance sheet is a picture at a point in time, and the income statement is a movie about a certain period. We need to somehow connect the picture and the movie. To do that, we add the net income earned during the year to the balance sheet of the end of the year. Interest is the reward for the bank for granting us a loan. Net income is the reward for the shareholders for making risk-bearing capital available. We add the Net Income earned during the year to Equity, in a sub-account called Retained Earnings. And the balance sheet balances!

That’s how the balance sheet and income statement fit together.

Philip de Vroe (The Finance Storyteller) aims to make strategy, finance and leadership enjoyable and easier to understand. Learn the business and #accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better stock market investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!

[aries]

Thank you, my teacher is soo trash, especially during online classes for quarantine. You saved my marks!

[ruslanivanov]

Sir, this is the most clear explanation of the BS and P&L relation that I have ever seen. I work in finance, but my work and experience has been always focused on the P&L, so I lack real knowledge of the BS. Your videos are extremely helpful for refreshing the knowledge.
Thanks!

[onelucian]

this is the best video on the subject, considering its length. thanks a lot!

[playwithvayofficial]

Very good video, thanks a lot! This is very clear and precise to comprehend as opposed to other similar channels out there. Much appreciated and keep up the great work.

[kauabarros]

Learned more in this Fidetham my entire High school career. Thanks chief 🤙🏾🤙🏾🔥

[yadagiriibusetty]

Well explained...Easy to understand for all who is not from financial background.

[gergobmx]

great refresher in less than 5 minutes, well done

[Zoliman]

This answers exactly what I didn't get before. Thanks a lot!

[omarzeyad]

I'm doing MBA degree but still visiting this channel, especially when it comes to my weakness calculus and finance. really thank you so much !

[domdompomodoro]

Excellent simple explanation. Thank you.

[ericbess]

Thank you...it was the pieces of the puzzle I was missing

[mingyangwang]

This is really helpful! Thank you so much!!

[natalia______]

Thank you so much for this video. It was really helpful. I’m getting ready for the interview. Refreshing my memory.

[loganyang]

Thank you, you are much better than my accounting lecturer!!

[lachoranchev]

Awesome vid - made a lot sense! Thanks
Can you do similar vids how balance sheet interact with cash flow statement and income statement with cash flow statement? If you have those already please provide links

[samuelong]

finally understand this topic, thank you!!

[vanessaalexander.r]

would you include things like income expenses, rent expenses, interest expenses or insurant expenses in a balance sheet?

[KrishanSingh-gzop]

1.I have read some articles which says that losses are shown on the asset side of the balance sheet !!
2. And i also know & have seen in companies balance sheets that losses are subtracted from retained earnings.

I am confused about the first statement, are both the statement true? Arent we double counting the effect of loss if we follow both the statements?.

[Malayamakiya]

Does The balance amount of balance sheet show the something our it is just for checking a mathematical accuracy.

[monirahmed]

why net loss includes in balance sheet as asset side?: