The primary role of a for-profit enterprise is to generate revenue and earn a profit. The income statement shows how well a company does this. Information shown on the balance sheet, when compared to the income statement, indicates how and how efficiently the company leveraged its resources in its profit-generating activities. Therefore, it is important to understand how the balance sheet relates to operating activities.
Assets, liabilities and equity are shown on balance sheets, which capture what your business owns and what it owes. Your income statement shows performance over a period of time -- typically a month, quarter or year. However, balance sheets show your company's financial holdings at a particular point in time. Balance sheets are driven by an accounting equation that must balance: total assets equal total liabilities plus total owner's equity.
On the balance sheet, you classify assets as short term, which includes cash and inventory, or long-term, which includes property and equipment. Short-term liabilities include account payables and lines of credit; long-term ones include mortgages and term loans. Owner's equity includes initial and additional contributions and retained earnings. The change in your short-term assets and liabilities from one month's balance sheet to another reflects the impact of your company's operating activities. In addition, net income from the income statement at the end of the year will show up in retained earnings on the balance sheet at the beginning of the next year.
The income statement, also called the profit and loss statement, records your company's operating activities. When you sell products or services, you generate revenue on the income statement. You receive that revenue as cash or account receivables, which both show as current assets on your balance sheet. If you sell products, you show the cost of the goods sold on your income statement and the corresponding reduction in inventory on your balance sheet.
When you incur operating expenses, you either pay these out of cash, which reduces cash on the balance sheet, or create accounts payable, which show as a current liability on the balance sheet. Alternatively, you may need to utilize an existing line of credit to pay your company's bills. This would appear as an increase in your credit line liability. In addition, net income from the income statement at the end of the year will show up in retained earnings on the balance sheet at the beginning of the next year.
The cash flow statement, which maintains a record of how a company's revenue and profit-generating -- its operating activities -- impact cash. It also records how your company uses its assets, how it incurs liabilities or how capital affects its cash flow and net cash position. Because of its intermediary position, the cash flow statement provides the information and data that clearly illustrates how your company's operating activities transfer to the balance sheet.