Understanding Financial Statements: Balance Sheet and Income Statement

The balance sheet and the income statement are the two most well-known documents used to assess a company's financial health, yet they are widely misunderstood. Here, we'll learn what these documents are for and what the differences are.

This article is taken from the Business management masterclass for entrepreneurs, business leaders, and managers on Tulipemedia !

🎯 Chapter objectives:

• Understanding the structure and role of the balance sheet and the income statement

• Discover the articulation between these two states

• Identify the major economic and financial indicators

🧾 The two fundamental financial statements

📊 The balance sheet

Photograph of the company's heritage at a moment in time T.

👉 Fundamental equation:

Assets = Liabilities

📈 The income statement

Film of the activity on a given period (often a year).

👉 Result = Products – Expenses

• Result > 0 → profit

• Result < 0 → loss

🔁 The balance sheet / income statement link

What is the relationship between the balance sheet and the income statement?

• THE net result from the income statement comes feed equity in the balance sheet. This concept is extremely important to understand, but if you have trouble formalizing it, know that it will take on its full meaning in the chapters to come. But what you need to remember is that the result of a company (what it has gained or lost over a year) will be housed in the "Equity" section of the balance sheet, in the liabilities (what the company owes, to the shareholders for example if the company is profitable, and if it is in deficit, it will owe more than what the shareholders had bet, which puts the company in a critical situation since it is living beyond its own means).

• The activity (e.g. sales reported by the income statement) modifies the stocks, THE receivables and the treasury. Indeed, a sale can be made and recorded as such in the income statement (so it's rather a good thing), but if the customer has not paid, this inflates the "accounts receivable" item on the balance sheet assets (and not the cash, which is also on the balance sheet assets). On the liability side, this sale will increase the net income, which is found on the balance sheet liabilities, which balances the accounts.

💡 Simplified example:

If a company sells €10,000 worth of products with €7,000 in expenses:

• Income statement : the net result is +3 000 €.
• Balance sheet : the asset increases by €10,000 (in the form of debt or cash), but in parallel, €7,000 is used to settle charges : this results either in a decrease in cash on the assets side or an increase in supplier debts on the liabilities side.
• The net result of €3,000 increases equity.

👉 The assets and liabilities therefore remain perfectly balanced.

This example is extremely important to understand because it firstly allows us to become aware that the balance sheet and the income statement do not tell the same story: the balance sheet reflects the company's financial situation (what it owns VS what it owes), whereas the income statement reflects the company's profit or deficit over a year.

However, this is a concept that is sometimes very vague for young business leaders, or managers who are not specialized in corporate finance, and who do not really understand how the balance sheet and the income statement are linked, and what the very essence of each of them is.

Thus, it is not uncommon to see some business leaders looking for their turnover in the balance sheet, their operating expenses (such as rent or electricity), or not understanding the concept of equity, or even working capital (which we will see in a future chapter).

In fact, to clearly illustrate the difference between the balance sheet and the income statement, we can say, for example, that it is pointless to look in the balance sheet to find your annual rent, your payroll or your turnover: this information is found in the income statement, the result of which will be included in the liabilities of the balance sheet. Conversely, social debts (salary debts) or rent debts can appear on the balance sheet if the company is late in paying: they will then be found in the liabilities (what it owes). This is why the balance sheet reports what the company has and owes (with the seniority of the years), while the income statement reflects the economic model of the company (only over the past year).

Here is a summary of what the balance sheet can tell us about the company:

• The level of debt (financial structure),
• Liquidity or cash flow tension (via FR, WCR, net cash flow),
• The level of investment (fixed assets),
• The ability to hold out over time (equity vs. debt),
• The need for short-term financing.

Don't panic, we'll break down all these concepts in the next chapters.

Here, however, is what the balance sheet does not tell us:

• It does not show the flows (cash inflows/outflows);
• It does not provide any information on how the company makes money.

The balance sheet provides an accounting picture of assets, useful for assessing financial strength, but it is not sufficient to understand the economic dynamics, profitability or strategy of a company.

To understand a business model, you need to:

• The income statement (activity flow),
• The cash flow statement (capacity to generate cash),
• And to another extent, a strategic or managerial analysis (which is not of an accounting nature).

📊 Illustrative example:

• Turnover: €300,000
• Total costs: €260,000
• Net profit: +€40,000

→ The details used to arrive at these €40,000 are not intended to appear in detail in the balance sheet. The €300,000 in turnover and the €260,000 in expenses are therefore not included in the balance sheet. Only their net difference (the result) is included in the liabilities (in equity):

• Share capital €50,000
• Reserves €10,000
• Result of the financial year +€40,000

🧠 In summary:

• The balance sheet does not show turnover or expenses,
• But it includes the result, the accounting consequence of these flows,
• 🔁 The result is the point of junction between the activity (income statement) and the company's financial situation (balance sheet).

Negative results and balance sheet

The question that one can ask, and that many business leaders have unfortunately encountered after several years of operation, is what happens if the net result is negative, particularly after several years, and how this is reflected in the balance sheet and in concrete reality.

As we said before, the net result provided by the income statement will be included in the company's equity, below the share capital (which is the amount contributed by the partners to the company).

If the result from the income statement for the past year is negative, it is logically still found in equity, but in negative value. It reduces the initial amount of equity.

The result, whether a profit or a loss, is reflected in the balance sheet by a change in equity:

• ✔️ A profit increases equity.
• ❌ A loss reduces equity.

If the company suffers several successive losses, equity can become very low, or even negative if the losses exceed the share capital. In this case, the company is in a negative net position (dangerous!), and it must rebuild its equity as quickly as possible, either by increasing capital (the partners put money back or bring in other shareholders), or by making profits quickly to bring the equity back into positive territory on the next balance sheet.

Otherwise, it may be in a situation of compulsory dissolution.

If a company continues to operate despite negative equity over time, this generally means that it is financing itself “elsewhere”, that is to say on credit, and often to the detriment of certain partners.

This is a case that is important to address because it often happens that the entrepreneur persists in continuing the activity of his company despite negative equity, while waiting for better days, without being aware of the spiral and without having anticipated it in advance due to a lack of knowledge:

When equity is negative:

• The company no longer has its own financial cushion (no more capital or reserves),
• It survives only thanks to debts: suppliers, loans, overdrafts, public aid, etc.
• She is delaying payments: to her suppliers, to Urssaf, to the tax authorities, and even to her employees.

This model is unstable because it relies on the trust of others. And as soon as a supplier or bank withdraws its trust, everything can collapse. The company could then no longer be able to purchase its raw materials, be sued for unpaid debts, and find itself insolvent and then liquidated.

Unfortunately, many small businesses survive on credit at the expense of their partners, and this is a fragile, unsustainable way of survival. which is held together by the inertia or tolerance of third parties, and which can have the perverse effect of "distorting" an entire market characterized by players who never live from their activity, and who perpetuate this bad practice with successors who make the same management errors.

Key indicators

Financial statements provide several key indicators, including a quick overview. We'll cover each of these indicators in detail in upcoming content.

1. Turnover (TO)
   → Volume indicator, the basis of all analysis, and the most famous indicator

2. Gross margin = turnover – cost of goods sold
   → Indicates the immediate profitability of sales

3. EBE (Gross Operating Surplus)
   → Operating profit before depreciation and taxes

4. Net result
   → The final “profit” or “loss”

5. Equity
   → What the partners have invested + what the company has earned and kept

6. Net cash flow
   → Final balance of cash after short-term debts

Without upstream accounting and the recording of invoices on a daily basis, it is impossible, for example, to estimate the overall purchase cost of goods sold over a given period, or the cost of raw materials purchased, and therefore impossible to establish these indicators, which are nevertheless essential for managing the business. This is why a business manager must imperatively record his purchase invoices in the accounts and monitor his payroll each month in order to estimate along the way whether his activity is profitable, or whether he needs to make adjustments.

For example, if after 6 months of activity he notices that his company is not generating enough profit and that he is barely below the break-even point, he can then consider several options:

• A slight increase in prices in order to achieve profitability while ensuring that any potential drop-out from customers is monitored;
• An increase in turnover through up-selling;
• An increase in sales volume through marketing actions, a loyalty program, partnerships or simply a reduction in prices, ensuring that this price reduction does indeed result in an increase in volume;
• A reduction in costs and the company's "lifestyle", or an optimization of processes;
• The elimination of an unprofitable product or service;
• A repositioning of the product or service;
• Or simply the choice to do nothing, while monitoring organic revenue growth.

Conversely, without a monthly dashboard, and without management over time, the entrepreneur navigates completely blindly, with turnover as the only indicator, which can very often prove misleading.

But again, if all this seems complicated, don't panic, we'll come back to it in detail in the coming chapters.

🧠 What to remember:

• THE balance sheet is a photo of the company's assets, with prior history (debt, assets, etc.).

• THE income statement is the positive or negative result over a given period (one year).

• The link between the two is essential to understanding financial dynamics, knowing that the result is incorporated into the balance sheet, at the liability level.

• These documents are the starting point for any analysis (functional, financial, strategic).

Feel free to subscribe to the blog and comment, and I'll see you soon for the next chapter,

👉 Next chapter: Learning to read, understand and interpret an income statement
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