Learn: Using Income Statements and Balance Sheets Together

Welcome!You've already learned how to interpret balance sheets and calculate important financial ratios. Now, let's build on that knowledge by exploring how income statements and balance sheets work together to provide a complete picture of a business's financial health.

What are Income Statements and Balance Sheets?Income statements show a business's financial performance over a period of time, including revenue, costs, and profit. Balance sheets show a snapshot of the business's assets, liabilities, and equity at a specific point in time. Together, they help stakeholders evaluate the profitability and stability of a business.

Why Use Them Together?While an income statement shows how much profit a business is making, the balance sheet reveals whether the business has enough resources to sustain itself. For example, a profitable business might still struggle with cash flow if it has too many liabilities or insufficient working capital.

Key Relationship: Profit and EquityThe profit shown on the income statement contributes to the equity on the balance sheet. If a business generates profit, it increases retained earnings, which is part of equity. Losses, on the other hand, reduce equity.

Analysing Cash FlowCash flow problems often arise when the balance sheet shows low liquidity, even if the income statement reflects profit. For instance, delays in collecting receivables or high inventory levels can tie up cash, affecting the balance sheet's current assets.

Using Ratios to Connect the StatementsRatios like the current ratio and ROCE combine data from both statements. For example, ROCE uses profit from the income statement and capital employed from the balance sheet to assess efficiency and returns.

Review Time!Great work! You've learned how income statements and balance sheets complement each other. Let's test your understanding with a few questions.

Final ThoughtsUnderstanding how income statements and balance sheets work together is crucial for evaluating a business's overall financial health. Keep practising with more examples to strengthen your skills!