The income statement and balance sheet are the two most important financial statements. Together, they create a comprehensive picture of your business’s finances that managers, investors, and creditors can use to facilitate various processes.
Despite being integrally connected, income statements and balance sheets have some significant differences. Let’s explore those differences to help you better understand how each report works.
What Is a Balance Sheet?
A balance sheet is a financial statement that presents a snapshot of your company’s assets, liabilities, and equity on a specific date. As a result, it’s also known as the statement of financial position.
Balance sheets are structured around the accounting equation that states:
Assets = Liabilities + Equity
You can always use that formula to make sure your balance sheet is accurate. If your equation doesn’t balance, something’s wrong.
Because of its subject matter, analyzing your business’s balance sheet is the best way to assess your liquidity and solvency. Those terms refer to your company’s ability to convert assets into cash and to pay its debts, respectively.
For example, a prospective lender might use your balance sheet to calculate financial ratios like your debt-to-equity ratio, which equals debt divided by equity. If it’s too high, the lender might decide you’re over-levered and can’t afford more debt.
Notably, because your balance sheet can only document a single day at a time, users of financial statements often compare one balance sheet to another for greater insight.
For example, you could compare your balance sheet on 12/31/2020 to your balance sheet on 12/31/2021 to determine how much your cash reserves grew during the calendar year.
What is Included in a Balance Sheet?
Your balance sheet should document your company’s assets, liabilities, and equity. Here’s what each one of those terms means and what kind of accounts they include.
Basic balance sheet components:
- Assets
- Liabilities
- Equity
First, your assets are the resources your business owns that you expect to provide some future economic benefit. Typically, that means you’ll be able to generate cash by selling or using them in your business.
Depending on how long you expect to hold an asset before realizing its economic value, it can be current or long-term. If you can turn it into cash within a year, it’s a current asset. If it’ll take longer, you have a long-term or noncurrent asset.
Current assets include accounts like cash and cash equivalents, inventory, and accounts receivable. Long-term assets include fixed assets like property and equipment.
Second, your liabilities are the debts you owe to third parties like lenders and suppliers. They represent fixed obligations that you have to fulfill. You can use them to get financing without giving up ownership of your business, though too much is dangerous.
Liabilities can also be current or long-term, but you often have to split accounts between the two. For example, the mortgage payments on your rental property due next year would be a current liability, but the rest of your loan is a long-term liability.
Finally, your equity is whatever you have left after subtracting your total liabilities from your assets. Also known as your net assets or net worth, it’s what the owners or shareholders of the business would receive if they were to liquidate the company.
Equity accounts include things like owner contributions, shares of company stock, and retained earnings.
What Is an Income Statement?
Your income statement measures your company’s revenues and expenses over a given period. In simple terms, that means it tracks what you earn and spend to calculate your financial performance. As a result, it’s also referred to as the profit and loss statement.
Income statements are structured around the equation that states:
(Revenue + Gains) - (Expenses + Losses) = Net Income
In simple terms, it documents how much money you earned during a period, how much you spent, and how much is left over.
Because of this, an analysis of your income statement is typically the best way to gain insight into your company’s profitability. Beyond the obvious calculation of your net income, you can also use it to review things like your gross profit and net profit margin.
Unlike balance sheets, income statements capture information over time, so even one of them can help you analyze your company’s trends. However, it’s still a good practice to compare them across multiple periods.
For example, you might compare your year-to-date income statement to your income statement from the same months last year. You’d be able to determine whether you’re on pace to beat your previous numbers.
What’s Included in an Income Statement?
Your income statement should include your business’s revenues, expenses, gains, and losses. Let’s explore each of those in turn.
First, your revenue accounts sit at the top of your income statement. They include everything your company earned from its day-to-day operations during the given period.
If you’re on the cash basis of accounting, that only includes money you’ve collected. However, if you’re on the accrual basis, it may also include money you’ve earned but not yet received.
Next are your expenses, which can fall into two categories: direct and indirect.
Direct expenses are involved in creating your product or providing your service. They’re also known as your cost of goods or services sold. Subtract them from your revenues to get your gross profit.
For example, say you sell custom wooden chairs. Your direct expenses would include the price of each chair’s raw materials and the labor costs you pay your craftspeople.
Your indirect expenses or operating expenses come next. They contribute to your business, but they aren’t directly involved in your product or service.
For example, advertising and administrative expenses are both indirect costs. Subtract them from your gross profit to get your operating income.
Finally, gains and losses go toward the bottom of the income statement. When you sell something, they equal the difference between your proceeds and your cost basis. Your cost basis usually equals your purchase price minus any accumulated depreciation.
For example, say you buy a building for $200,000. After three years of depreciation, its cost basis is $175,000. If you sell it for $225,000, you’d show a $50,000 gain on your income statement. If you sell it for $150,000, you’d have a $25,000 loss.
What is the Difference Between an Income Statement and a Balance Sheet?
Your income statement tracks your revenues, expenses, gains, and losses over time to arrive at your net income. Meanwhile, a balance sheet displays your total assets, liabilities, and equity on a specific date.
Now that we’ve covered how these two financial statements fit into your general financial reporting, let’s highlight their most notable differences and review them in greater detail.
Accounts
One of the fundamental differences between the two financial statements is that they hold different accounts. Income statements measure your revenues, expenses, gains, and losses, while your balance sheet documents your assets, liabilities, and equity.
They’re also structured around separate accounting equations, which are:
- Income statement: (Revenue + Gains) - (Expenses + Losses) = Net Income
- Balance sheet: Assets = Liabilities + Equity
Knowing why these accounts go together and how they relate to one another is critical to understanding how money flows through your business.
Timing
Another fundamental difference between income statements and balance sheets is that they measure different lengths of time. Namely, income statements cover extended periods, while a balance sheet can only ever document your position on a single date.
That seems like a superficial point, but it impacts their utility significantly. In fact, it’s one of the main reasons you need to use both statements in conjunction to draw meaningful conclusions.
In simple terms, your balance sheet tells you where your business is on a given day. Your income statement tells you exactly what you did to get there. One without the other tells an incomplete story.
Uses
The most practical difference between income statements and balance sheets is that they fulfill different functions for users of financial statements.
Generally, income statements are better for analyzing your business’s profitability. You can back into your net income for a period by comparing your balance sheet before and after, but you need your income statement to dig into the details.
For example, you can use one to facilitate your cash flow forecasting or review a variance between a budgeted and actual operating expense.
Conversely, balance sheets are better for analyzing your business’s liquidity and solvency. For example, say your business is currently making interest-only payments on a long-term loan that ends in a balloon payment.
A potential investor could see from your income statement that you have enough total revenue to cover your current monthly obligations. However, that would be dangerously misleading if they didn’t also look at your balance sheet.
They'd likely also want to review your long-term loan amounts and compare them to your cash reserves to have an accurate picture of your company’s ability to pay its debts.
In addition to tracking your business transactions, accounting software can automatically generate your financial statements! Fortunately, Lendio offers free accounting software for small businesses. Give it a try today!
FAQs
How Are Balance Sheet and Income Statement Related?
The primary connection between your balance sheet and income statement is that your net income flows from your income statement into the retained earnings account on your balance sheet.
However, that’s not the only link between the two statements. You’ll also find that transactions often affect both your balance sheet and income statement simultaneously.
For example, say you use some of your cash reserves to pay a debt. You’d have to decrease your cash and debt accounts on the balance sheet, but you’d also have to increase your interest expense on the income statement.
Which Is More Important, Income Statement or Balance Sheet?
Neither the income statement nor the balance sheet is more important than the other. Each one's significance is situational and depends on the user, what information they’re looking for, and why they need it. In many cases, they’re equally necessary.
For example, say you’re applying for a loan, and your lender reviews both of your financial statements to determine whether you’re likely to pay back the account.
Using your balance sheet, they might check your debt-to-equity ratio and compare your current assets to your current liabilities. However, they’d still want to review your income statement to see if you have enough cash flow to afford more monthly payments.
What Comes First, Income Statement or Balance Sheet?
In theory, the income statement comes before the balance sheet. Your net income, which is the final result of your income statement, flows into your retained earnings, a balance sheet account.
That said, it’s something of a chicken and egg situation in practice. These two financial statements work in tandem, and you’ll often need to adjust them simultaneously to track your activities.
For example, say you pay your office’s rent with cash. You’d need to reduce your cash account, then increase the rent expense account. Of course, cash is on the balance sheet, while rent expenses go on the income statement.
*The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.
