Financial Statement Series: Relationship Between the Income Statement and Balance Sheet

Rylan Kaliel
Jun 16
10 min read

Updated: Jun 20

Man in a blazer uses a laptop displaying charts. Tablet on table. Bright setting, focused on data analysis. Calm, concentrated mood.

In the previous blogs we have discussed the Balance Sheet, the Income Statement and its components. In this blog we will discuss what the relationship between the two reports are and what are the major differences between them.

Understanding the Income Statement and Balance Sheet

Let’s first review what the Balance Sheet and Income Statement are. The two reports are two of the most fundamental financial statements.

The Balance Sheet shows what the company owns and owes. The Balance Sheet reflects all the changes to the business since the inception of the company to-date (like an elephant the Balance Sheet never forgets).

The Income Statement illustrates what a business sold and the costs it incurred in pursuit of those sales. The Income Statement resets after each period. This means that you will start every year with zero revenue and zero expenses (a clean slate each time).

Each report will serve a distinct purpose and provides unique insights into the health of a business. The relationship between these reports can be best understood through their interplay in representing a company’s financial activity.

What Does the Income Statement Represent?

As mentioned above the Income Statement captures a period’s financial performance by presenting revenues, expenses, and profits (or losses). This provides a dynamic view, answering the question: "How did the business perform over a specific time frame?"

Example: For instance, a company might report $500,000 in revenue, $300,000 in operating expenses (direct and indirect costs), and $50,000 in net profit for the quarter. These figures reflect the company’s earnings and spending during that period. This allows you to analyze the profitability of your business. If your goal is to have $150,000 in profit in a year, then you are on track to meet this goal after the first quarter.

Let’s say your goal is to make $200,000 instead. You can use the report to analyze what actions you can take to meet this goal. Maybe the answer is to shop around for new insurance or utility provider. Maybe it is to spend more time cultivating new relationships or strengthening existing relationships with customers to earn more revenue. What ever the answer is the Income Statement helps you get started.

What Does the Balance Sheet Represent?

On the other hand, the Balance Sheet offers a snapshot of the company’s financial position at a single point in time, detailing assets, liabilities, and equity. It answers "What does the business own and owe right now?"

Example: A Balance Sheet might show that a company has $2 million in assets, $1.5 million in liabilities, and $500,000 in equity as of the end of the year.

The most important function of the Balance Sheet is twofold.

Do you have enough liquid assets (cash, account receivables, inventory) that you can turn into cash to pay your current liabilities such as your vendors, rent for the period and such.
In the long-term will you have enough assets to cover your long-term liabilities.

In the next section we will discuss what the relationship between the two reports are.

The Connection Between the Two Reports

The Balance Sheet and Income Statement are closely interconnected, as they both offer insights into the financial health of a business. The simplest way of looking at is this every dollar you make or spent to earn revenue makes it way on the Balance Sheet.

Revenue, recorded in the Income Statement, directly impacts accounts receivable (AR) on the Balance Sheet. For example, if a company earns $100,000 in sales but hasn’t collected all the payments yet, this revenue will increase its AR, showing outstanding amounts owed to the business.

Expenses, on the other hand, are directly tied to accounts payable (AP) on the Balance Sheet. If the company incurs $50,000 in operating expenses, and some of these costs—like supplier fees—haven’t been paid yet, they will reflect as AP, demonstrating the business’s short-term obligations.

These connections illustrate how operational activities, reflected in the Income Statement, affect the broader financial position captured by the Balance Sheet. By analyzing both, businesses can strategize effectively—for instance, prioritizing collections to reduce AR or controlling costs to manage AP more efficiently.

Amortization and depreciation, while not necessarily cash expenses, play vital roles in both the Income Statement and the Balance Sheet. Amortization refers to the gradual allocation of the cost of intangible assets over their useful life. For example, if a company acquires a patent worth $100,000 with a useful life of 10 years, it records $10,000 annually as amortization expense on the Income Statement. This impacts the Balance Sheet by gradually reducing the book value of the patent under intangible assets.

Depreciation, similarly, involves spreading the cost of tangible, long-term assets—like machinery or buildings—over their useful lives. Suppose a company purchases equipment for $50,000 with an expected life of 5 years. It might allocate $10,000 annually as depreciation expense on the Income Statement. On the Balance Sheet, this is reflected as a reduction in the carrying value of the asset within the property, plant, and equipment (PPE) category.

Both amortization and depreciation provide a structured way to account for the wearing out or consumption of assets, which affects profitability and asset value over time. Crucially, these expenses do not directly impact cash flow in the reporting period; instead, they represent the gradual transfer of asset costs to the Income Statement, ensuring accuracy in accounting while maintaining transparency in financial reporting.

Net income from the Income Statement also feeds into equity on the Balance Sheet. If a company reports $20,000 in net profit for the period, this amount will be added to retained earnings, a key component of equity (see our Equity blog post for more details). Over time, consistent profitability boosts equity, enhancing the financial stability of the business.

The one area of the relationship between the two reports that is not mentioned often but plays a crucial role in understanding the health of the business is the changes in cash.

Changes in cash flow occur as a direct result of variations in revenues and expenses. When a company generates revenue, it may not immediately translate to cash inflow if the sales are on credit, thereby increasing accounts receivable (AR). Conversely, expenses reduce cash immediately if paid upfront or add to accounts payable (AP) if payment is deferred. For example, if a business earns $100,000 in revenue for a period but only collects $70,000 in cash due to outstanding invoices, its cash inflow is reduced momentarily by the $30,000 still tied up in AR.

Similarly, if the company incurs $50,000 in operating expenses but defers $20,000 of these costs, this deferral temporarily preserves $20,000 in cash. However, these obligations remain as short-term liabilities, requiring careful cash management to ensure liquidity when due. By observing these dynamics, businesses can identify opportunities to optimize cash flow, such as accelerating collections on AR or negotiating better terms with suppliers to manage AP more effectively.

The Cash Flow Statement, which tracks inflows and outflows of cash, acts as a bridge between the Income Statement and Balance Sheet, offering a detailed view of how operational activities impact liquidity. For instance, an increase in depreciation expense on the Income Statement might reduce net income, but since it is a non-cash charge, it does not impact the operating cash flow in the Cash Flow Statement. This interconnected framework highlights how managing cash flow is just as critical as managing profits

We will be discussing and working through the Cash Flow Statement in our upcoming blogs in-depth.

In the next section we will discuss the differences between the Balance Sheet and Income Statement.

Major Differences Between the Income Statement and Balance Sheet

The Income Statement and Balance Sheet are two fundamental components of financial reporting, each serving distinct but complementary purposes. Understanding their differences is pivotal to analyzing a company's financial health and performance.

Timing: The Income Statement captures the financial performance of a company over a specific period, such as a quarter or year. It focuses on revenues, expenses, and profits, reflecting the company's operational activities during that timeframe. Conversely, the Balance Sheet is a snapshot of the company’s financial position at a single point in time, summarizing assets, liabilities, and equity.

Purpose: The Income Statement is designed to measure profitability, detailing how much revenue the company generates, and the associated costs incurred to earn that revenue. It answers the question: "How well did the company perform during this period?" The Balance Sheet, however, emphasizes financial stability, showing what the company owns (assets), owes (liabilities), and the net value attributable to shareholders (equity).

Structure: The Income Statement presents a flow of transactions, starting with revenues and deducting costs to arrive at net income. Key components include gross revenue, operating expenses, and net profit. The Balance Sheet, by contrast, presents a point in time and consists of three sections: assets, liabilities, and equity, which are organized according to the accounting equation: Assets = Liabilities + Equity.

Cash vs Non Cash: While the Income Statement includes both cash and non-cash items (e.g., depreciation or amortization) and there respective movements, the Balance Sheet captures the cumulative impact of these items on cash and non-cash asset values. For instance, depreciation reduces the book value of equipment on the Balance Sheet but does not directly affect cash flow in the Income Statement period.

Key insights: The Income Statement is about performance and profitability, while the Balance Sheet is about position and stability. Together, they offer a holistic view of a company’s operations and financial standing.

Ratios for the Income Statement, Balance Sheet, and Combined Reports

Financial ratios are invaluable tools for analyzing the relationship between various elements of financial statements. Below is a comprehensive list of ratios categorized by the report they are derived from, along with examples of their calculations.

Income Statement Ratios

These ratios help evaluate a company's profitability and efficiency based on its Income Statement.

Gross Profit Margin

Gross Profit Margin: This ratio measures how much money is left over from revenue after paying for the cost of goods sold (COGS). It is calculated as:

Gross Profit Margin = (Gross Profit / Revenue) × 100

Example: If a company earns $500,000 in revenue and its cost of goods sold is $300,000, then:
- Gross Profit = $500,000 - $300,000 = $200,000
- Gross Profit Margin = ($200,000 / $500,000) × 100 = 40%
- This means 40% of revenue is retained as gross profit.

Net Profit Margin

Net Profit Margin: This indicates how much of the revenue remains as profit after all expenses, taxes, and costs. It is calculated as:

Net Profit Margin = (Net Profit / Revenue) × 100

Example: If a company has a net profit of $50,000 on revenue of $500,000, then:
- Net Profit Margin = ($50,000 / $500,000) × 100 = 10%
- This means the company keeps 10% of its revenue as profit.

Operating Expense Ratio

Operating Expense Ratio: This shows what proportion of a company’s revenue is spent on operating expenses. It is calculated as:

Operating Expense Ratio = (Operating Expenses / Revenue) × 100

Example: If a company spends $150,000 on operating expenses and earns $500,000 in revenue, then:
- Operating Expense Ratio = ($150,000 / $500,000) × 100 = 30%
- This means 30% of revenue is used for operating costs.

Balance Sheet Ratios

These ratios focus on evaluating a company’s financial position, including its liquidity and solvency.

Current Ratio

Current Ratio: This measures the company’s ability to meet short-term obligations with its short-term assets. It is calculated as:

Current Ratio = Current Assets / Current Liabilities

Example: If a company has $200,000 in current assets and $100,000 in current liabilities, then:
- Current Ratio = $200,000 / $100,000 = 2
- This means the company has $2 of assets for every $1 of liabilities.

Debt-to-Equity Ratio

Debt-to-Equity Ratio: This reflects how much debt the company is using compared to its equity. It is calculated as:

Debt-to-Equity Ratio = Total Liabilities / Total Equity

Example: If a company has $300,000 in liabilities and $500,000 in equity, then:
- Debt-to-Equity Ratio = $300,000 / $500,000 = 0.6
- This means the company uses 60 cents of debt for every dollar of equity.

Debt-to-Asset Ratio

Debt-to-Asset Ratio: This reflect how much debt the company is using compared to its asset. It is calculated as:

Debt-to-Asset Ratio = Total Liabilities / Total Assets

Example: If a company has $300,000 in liabilities and $1,000,000 in assets, then:
- Debt-to-Asset Ratio = $300,000 / $1,000,000 = 0.3
- This means the company uses 30 cents of debt for every dollar of assets.

Asset Turnover Ratio

Asset Turnover Ratio: This measures how efficiently a company uses its assets to generate revenue. It is calculated as:

Asset Turnover Ratio = Revenue / Total Assets

Example: If a company earns $600,000 in revenue and has $1,200,000 in total assets, then:
- Asset Turnover Ratio = $600,000 / $1,200,000 = 0.5
- This means the company generates 50 cents of revenue for every dollar of assets.

Combined Ratios

These ratios use elements from both the Income Statement and the Balance Sheet to provide a broader view of financial health.

Return on Equity

Return on Equity (ROE): This shows how effectively a company uses shareholders’ equity to generate profit. It is calculated as:

ROE = Net Income / Shareholders’ Equity

Example: If a company has a net income of $100,000 and shareholders’ equity of $400,000, then:
- ROE = $100,000 / $400,000 = 0.25 or 25%
- This means the company generates a 25% return on shareholders’ equity.

Return on Assets

Return on Assets (ROA): This measures how efficiently a company uses its assets to generate profit. It is calculated as:

ROA = Net Income / Total Assets

Example: If a company has a net income of $100,000 and total assets of $800,000, then:
- ROA = $100,000 / $800,000 = 0.125 or 12.5%
- This means the company generates a 12.5% return on its assets.

Debt Service Coverage Ratio

Debt Service Coverage Ratio (DSCR): This assesses a company’s ability to pay its debt obligations using its net operating income. It is calculated as:

DSCR = Net Operating Income / Total Debt Obligations

Example: If a company has a net operating income of $300,000 and total debt obligations of $250,000, then:
- DSCR = $300,000 / $250,000 = 1.2
- This means the company earns 1.2 times the income needed to service its debt.

By understanding these ratios, even those without a financial background can gain valuable insights into a company’s performance, position, and overall health.

Summary

Understanding the similarities and differences between the Income Statement and Balance Sheet is vital for managing your business’s finances, understanding your current financial situation, and planning your businesses future effectively. It enables you to identify what is going on in your business, where your money is going, the value of your assets, and how to manage your overall financial health. By keeping a close eye on these statements, you can make informed decisions that enhance your profitability and financial position to ensure the sustainability of your operations.

Your business's success depends on a sound financial foundation. Understanding these financial statements will not only help you effectively manage your business but will also prevent financial difficulties that could jeopardize your operations. Remember, it’s essential to treat your business's finances with the same diligence and care as you would your own health.

For expert guidance and support, reach out to KLV Accounting. Our team is dedicated to helping you understand and manage your expenses efficiently. Contact us today for any accounting needs or questions about the segment above.

In the next blog we will discuss the Cash Flow Statement.

KLV Accounting, a Calgary-based accounting firm, is here to help. Contact us today to enhance your financial strategy, minimize your taxes, and drive business success! For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.