How are a company's financial statements connected?

When you do research on different companies by looking at their annual reports, you will typically come across two separate financial statements: the balance sheet and the income statement (also known as the statement of profit and loss). These two statements are very significant for companies as they can be used to describe the company's health and effectiveness of management.

Balance Sheet - B/S
The balance sheet gives investors a general overview of a company's financial situation. That is, it tells investors exactly what a company owns (assets) and who it owes (liabilities).

Assets and liabilities are listed in order of liquidity (relative ease of convertibility to cash), from most liquid to least liquid. Assets appear on the left hand side of the balance sheet and liabilities on the right hand side. For simplicity's sake, think of a B/S as an indicator of net worth: that is, how much a company is worth "on the books."

Income Statement – I/S
The income statement tells investors about the company's profits and losses for a specific time period. Expenses are subtracted from income to determine a firm's profit or loss. Unlike the B/S, the I/S doesn't look at the company's financial health (total net worth). Instead, it looks at how much revenue a company is able to create. If you were to think of the B/S as an indicator of net worth, you can think of the I/S as a company's profitability: that is, how much it can make in a given time frame.

These two statements are intertwined and should be looked at by all people who are considering investing their hard earned money in a particular company. You should look at a company's B/S to see exactly how much it is worth (remember, this is a book value representation rather than market capitalization), and look at the I/S to see how profitable the company is. Obviously, if it has a negative net worth (its liabilities are greater than its assets) or if it has a negative income, then the company might not be the best place to invest your money.

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