So far we have been considering the balance sheet by itself. But here’s one of the best-kept secrets in the world of financial statements: a change in one statement nearly always has an impact on the other statements. So when you’re managing the income statement, you’re also having an effect on the balance sheet.
To see the relationship between profit, from the income statement, and equity, which appears on the balance sheet, we’ll look at a couple of examples. Here’s a highly simplified balance sheet for a brand-new (and very small!) company:
Assets
| Cash | $25 |
| Accounts receivable | 0 |
| Total assets | $25 |
Liabilities and Owners’ Equity
| Accounts payable | $ 0 |
| Owners’ equity | $25 |
Say we operate this company for a month. We buy $50 worth of parts and materials, which we use to produce and sell $100 worth of finished product. We also incur $25 in other expenses. The income statement for the month looks like this:
| Sales | $100 |
| Cost of goods sold | 50 |
| Gross profit | 50 |
| All expenses | 25 |
| Net profit | $ 25 |
Now, what has changed on the balance sheet?
Thus, the balance sheet at the end of the month looks like this:
Assets
| Cash | $ 0 |
| Accounts receivable | 100 |
| Total assets | $100 |
Liabilities and Owners’ Equity
| Accounts payable | $ 50 |
| Owners’ equity | $ 50 |
| Liabilities and owners’ equity | $100 |
As you can see, that $25 of net profit becomes $25 of owners’ equity. On a more detailed balance sheet, it would appear under “owners’ equity” as retained earnings. That’s true in any business: net profit increases equity unless it is paid out in dividends. By the same token, a net loss decreases equity. If a business loses money every month, liabilities will eventually exceed assets, creating negative equity. Then it is a candidate for bankruptcy court.
Note something else about this simple example: the company wound up that month with no cash! It was making money, and equity was growing, but it had nothing in the bank. So an entrepreneur needs to be aware of how both cash and profit interact on the balance sheet. This is a topic we’ll return to in part 4, when we take up the cash flow statement.
The relationship between profit and equity isn’t the only link between changes in the income statement and changes on the balance sheet. Far from it. Every sale recorded on the income statement generates an increase either in cash (if it’s a cash sale) or in receivables. Every payroll dollar recorded as COGS or in operating expenses represents a dollar less on the cash line or a dollar more on the accrued-expenses line of the balance sheet. A purchase of materials adds to accounts payable, and so on. And of course, all these changes have an effect on total assets or liabilities.
Overall, if you tell your managers that their job is to boost profitability, they can have a positive effect on the balance sheet, just because profits increase equity. But it isn’t quite so simple, because it matters how those profits are achieved, and it matters what happens to the other assets and liabilities on the balance sheet itself. For example:
Ideally, your managers would themselves be financially intelligent enough to step back now and then and look at the big picture. They would consider not just a line item on the income statement but the balance sheet as well (and the cash flow statement, which we’ll get to shortly). If they can do this, they will be better managers—and will help you build a stronger company.
Remember, we said at the beginning of this part that savvy investors typically pore over a company’s balance sheet first. The reason is that the balance sheet answers a lot of questions—questions like the following:
These are simple, basic questions, of course. But they provide you with a deeper understanding of where your business stands than profit alone. Profit is important, and the data in the income statement helps you manage day to day. But company owners and other investors can learn much more from a detailed examination of the balance sheet and its footnotes, and from comparisons between the balance sheet and other statements. How important is goodwill to the company’s “total assets” line? What assumptions have been used to determine depreciation, and how important is that? (Remember Waste Management.) Is the “cash” line increasing over time—usually a good sign—or is it decreasing? If owners’ equity is rising, is that because the company has required an infusion of capital, or is it because the company has been making money?
The balance sheet, in short, helps show whether a company is financially healthy. All the statements help you make that judgment, but the balance sheet—a company’s cumulative GPA—may be the most important of all.
If you would like to practice what you have learned (and give yourself another break from reading), please turn to the balance sheet exercise in appendix B.