Balance sheets and income statements are two forms of financial information a company prepares annually, quarterly or even more frequently. They both measure performance over a given period of time. However, balance sheets measure the actual net worth of a company, based on assets. Income statements measure the profitability of a company, based on income. By combining the two, an investor can get a clear picture of a company's financial strength.
Factors on a Balance Sheet
A balance sheet describes the formula: Assets = Equity - Liabilities. Assets are the net worth of a company. Assets are those items a company could sell to generate cash if it went bankrupt tomorrow. To determine how much a company has you must consider its debt. This is where equity and outstanding liabilities come in. Nearly all business assets start as debts. A business takes a loan to purchase equipment, retail space or computer systems. Since the lender still owns the assets at this point, they are actually liabilities. As the company begins to repay debts, it builds equity in the products. The equity grows with each payment, and the liability shrinks at the same time. At any given point, a business should have more equity than it does debt. This would result in a positive net worth and a positive asset base on the balance sheet.
Income Statement Factors
An income statement relates solely to cash flow in the formula: Income = Inflow - Outflow. It is not a measure of the innate worth of a company; instead, it is only concerned with how much income the company generates in a day, month, quarter, year or longer. Over that given period, a company reports its cash inflow. This is money from any profitable endeavor, including sales of products, services or assets, such as stock. Any cash coming in the door goes into the positive column. Then, a company calculates its total cash outflow. This may be a debt payment, a purchase, income to employees or dividends to stock holders. Any money out the door is cash outflow and will be included on an income statement. If the company earns more than it spends, it has a positive income.
Relation of Income Statements and Balance Sheets
Often, balance sheets and income statements overlap. For example, a company may make a payment on a debt for a piece of factory equipment. This goes on the outflow side of an income statement, but it also builds the equity side of a balance sheet at the same time. So, the company has not truly lost any money. In the reverse, a company may have to sell off an asset to generate profit. Here, the action may appear positive on the income statement because it increased cash inflow. However, it also decreased equity on the balance sheet, resulting in a loss of assets. An investor must look at the way these two planes intersect in order to understand if a company is in a good financial position.