Have you ever wondered what effect your income statement has on your balance sheet, or if it does at all? Well, we can definitely say that it does. First off, we’ll explain what an income statement is and then what a balance sheet is. Following that, we can discuss some of the effects the balance sheet is impacted by.
So, what exactly is an income statement? An income statement is a financial statement that reflects a company’s revenue and operating expenses, showing how profitable the company is or isn’t for a specific period of time. You may have heard your accountant or bookkeeper refer to this by various names, including profit and loss statement, earnings statement, statement of operations, etc. This is not a definitive list but rather just an example of a few of the names you may have heard.
Next up, what is a balance sheet? What does it show a business owner about their business? A balance sheet is another type of financial statement that uses the equation “assets = liability + shareholder’s equity” to give the owner a look into their company’s financial standing. This statement provides a breakdown of what the company owns, fixed assets such as vehicles, and other assets, such as accounts receivable. It also shows what the company owes, such as payroll taxes and different liabilities, whether they are current liabilities like accounts payable or long-term liabilities such as a car loan. Finally, the balance sheet and other critical financial statements are used to calculate financial ratios used to guide the company.
Now that we have established what an income statement is and what a balance sheet is, let’s look at how the income statement affects the balance sheet.
When a company sells goods or services to its customer, it receives income from the sale, which is reflected on the company’s income statement as revenue. Therefore, sales or revenue are reflected on the profit and loss; however, they have balance sheet counterparts that fluctuate based on sales. Therefore, when sales are recognized on the profit and loss, accounts receivables will decrease since this report shows what was owed to the business.
Once revenue is reduced by the cost of goods sold and operating expenses on the income statement, your bottom line is your net income. The net income can help you understand how much cash flows onto the balance sheet. For example, when a company sees a net profit, the balance sheet will see adjustments in multiple accounts depending on how that net profit is allocated.
Remember, those principal payments to loans and owner’s draws are not reflected in your net income, so when looking at your net income compared to what reaches your bank account, you must account for those payments. Similarly, if you have a loss on your income statement, you may see a more significant loss in your bank to attribute to those other types of payments.
Net income also affects retained earnings, the last line item on the balance sheet, which shows the company’s lifetime net profit or loss. Retained earnings helps you to evaluate the net worth of your company.
When it comes to purchases of buildings, land, and vehicles, the balance sheet and income statement are affected depending on the purchase method. Depreciation is an expense on the income statement that reflects the use and loss of value of most fixed assets over the years. Depreciation directly affects the balance sheet by showing a reduction in your assets to create a lower tax value than when original purchase price. Most accountants will do this when filing taxes at the end of the year to ensure your company sees the most significant benefit.
When an asset is bought through financing, the interest accrued on each payment is an expense, affecting the net profit. In addition, the other portion of the loan payment involves the balance sheet as the principal amount is applied to the loan in the liabilities section.
As you can see, it’s essential to have both the income statement and the balance sheet to help accurately create a financial picture of your company’s financial wellness. In addition, a business owner working with their accountant or bookkeeper to learn what critical financial statements are saying is very beneficial. The income statement, balance sheet, and information provided by each piece of the accounting puzzle can be crucial in assessing and planning the best financial options for the business to grow and profit
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