Which is More Important: The Balance Sheet or the Income Statement?
Contributors
Which financial statement is more important, the balance sheet or income statement? Many would submit the balance sheet is most important because it offers a more comprehensive view of a company’s financial health. Others would say the income statement because it shows profit generation capability. Both are reasonable arguments, but each presents a limited perspective.
Understanding the Balance Sheet
The balance sheet measures a company’s ability to meet short-term and long-term financial obligations. It is a snapshot of a company’s financial position at any given time and reflects a company’s financial health. The balance sheet can determine a company’s viability and sustainability and is a tool to compare against industry competitors. It is also helpful in assessing return on investment (ROI) because it measures leverage and sources of capital deployed to finance assets.
Understanding the Income Statement
The income statement measures business performance and profitability over a specific period. It helps business owners make decisions regarding necessary investments in expenditures. It also provides insights into a company’s operations and efficiency of management. The income statement can assist with identifying areas where businesses can reduce potential costs or increase revenue. It is an effective tool for measuring or improving ROI.
How External and Internal Stakeholders Use Financial Statements
Both financial statements are valuable to external and internal stakeholders. External stakeholders include investors, governmental agencies (through taxes) and vendors/risk management companies. Investors use the financials to know if companies are deploying their funds appropriately and gauge their investment’s performance. Governmental agencies want to know if a company is compliant with specific laws and regulations. It helps agencies like the IRS determine if businesses are reporting appropriate tax liabilities. Suppliers and risk management companies want to know if there should be a concern with payment terms or extending relative liability insurance coverage.
Internal stakeholders include owners, management, employees and the board of directors. Owners value the financial statements similarly to external investors. They want to be assured their investment is safe and see how much return it has generated. Management uses the financial statements to make operational decisions relative to resource deployment, leveraging debt and optimizing cash flow. Assessing historical performance and future forecasts through these financial statements can help an employee understand whether their job is a safe/smart route for the future. The board of directors uses the financial statements to design a strategic position relative to their industry and ensure the implementation of objectives is successful.
Understanding the Cash Flow Statement
Ultimately, the cash flow statement connects the balance sheet and income statement. The cash flow statement provides a detailed picture of cash inflows and outflows in a business’s operations. Cash flow from operations shows the cash generated by ongoing operations, marrying “cash” profits with the conversion of the business cycle to cash (raw materials to inventory to goods/services sold to cash collected on revenue). Cash flow from investing activities measures cash generated from internal capital. Cash flow from financing activities provides the level of cash generated by external financing, such as bank debt and the cash outflow associated with debt obligations.
The balance sheet and income statement are uniquely important and contribute to informing stakeholders about the company. The cash flow statement is the medium that bridges these two financial statements and the crucial metrics they define. It drives the understanding of ongoing operating cash flow, nonrecurring cash flow generation, the conversion of the sales cycle to cash, comparative cash flow generation over time, operating and financial leverage, how much growth potential a company possesses, and the efficiency of its operations.
Balance Sheet vs. Income Statement
So, which more important: the balance sheet or the income statement? They BOTH are essential, and the cash flow statement is the critical source that marries the information in these two statements together!
If you need help developing key industry-specific metrics for your company which marry operations and finance and can help to propel your growth plans, and assess these implications for your business goals, our Corporate Accounting professional team is here to help. Contact us for more information.
