Financial statements are like puzzle pieces that fit together to show a company's financial picture. The balance sheet and income statement work hand in hand, with net income flowing into retained earnings and impacting shareholders' equity. This connection helps paint a complete financial portrait.

Understanding how these statements interact is crucial for grasping a company's financial health. The income statement shows earnings, while the balance sheet reflects the resulting changes in assets, liabilities, and equity. Together, they tell the story of a company's financial journey.

The Relationship between the Balance Sheet and the Income Statement

Net income and retained earnings

• Net income represents the company's total earnings for a specific period after subtracting all expenses from revenues (salaries, rent, cost of goods sold)
• Flows into the balance sheet through the retained earnings account, a component of shareholders' equity
  • Positive net income increases retained earnings, while negative net income decreases retained earnings
• Changes in retained earnings affect the balance sheet by altering total shareholders' equity and total assets or liabilities
  • Increase in retained earnings results in an increase in shareholders' equity and total assets (cash, inventory)
  • Decrease in retained earnings results in a decrease in shareholders' equity and total assets

Flow of financial statement information

• Income statement, statement of retained earnings, and balance sheet are interconnected financial statements
• Income statement reports the company's revenues, expenses, and net income for a specific period
  • Net income is the starting point for the statement of retained earnings
• Statement of retained earnings reconciles beginning and ending balances of retained earnings for a specific period
  1. Starts with beginning retained earnings balance
  2. Adds net income (or subtracts net loss) from income statement
  3. Subtracts dividends paid to shareholders
  4. Ends with ending retained earnings balance
• Ending retained earnings balance from statement of retained earnings flows into shareholders' equity section of balance sheet
  • Balance sheet presents a snapshot of company's assets, liabilities, and shareholders' equity at a specific point in time (December 31, 2022)
• Cash flow statement complements these financial statements by showing the inflows and outflows of cash during a specific period

Expenses vs payables

• Expenses on income statement represent costs incurred by company during a specific period to generate revenue
  • Cost of goods sold, salaries, rent, utilities, depreciation
  • Subtracted from revenues to calculate net income
• Payables on balance sheet represent company's short-term obligations or liabilities from purchasing goods or services on credit
  • Accounts payable, salaries payable, taxes payable
  • Recorded as liabilities on balance sheet until paid off
• Relationship between expenses and payables:
  • When expense is incurred, recorded on income statement
  • If expense not paid immediately, creates a payable on balance sheet
  • When payable is settled, reduces liability on balance sheet, but does not affect income statement again
• This relationship is based on accrual accounting principles

Accounting Principles and Analysis

• Financial statements are prepared according to generally accepted accounting principles (GAAP)
• Double-entry bookkeeping ensures that each transaction affects at least two accounts, maintaining the balance between assets, liabilities, and equity
• Financial ratios are used to analyze the relationship between different items on the balance sheet and income statement, providing insights into a company's financial health and performance