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Balance Sheet vs. Income Statement

Which is more important to look at for investing: balance sheet or income statement?

The balance sheet shows a company's financial position at a point in time, while the income statement records the company's performance over a given time period.

Looking at it different, the balance sheet is (basically) the sum of all previous income statements and all previous transactions with equity participants (as these don't go through the income statement).

The balance sheet equation is: ASSETS = LIABILITIES + EQUITY...where EQUITY is the sum of all previous capital transaction, profits and losses.

Generally speaking, the balance sheet is reflective of the liquidity, solvency and financial stability of a company.  Similiarly, the income statement shows the company's growth and ability to produce profits, which is after all the aim of all listed companies.

Although there are rare exceptions with regards to the relevance of the balance sheet in, for example, asset management companies or investment companies, where the balance sheet becomes reflective of the company's growth (in assets) as well.  For the purposes of this article, these rare cases will be ignored.

The balance sheet and its notes gives an investor a feel for the financial stability of the company.  From the balance sheet debts can be compared to assets and equity (Debt:Equity and Debt:Assets ratios), the ability of the company to meet its short-term obligations (Current and Quick ratios) and its ability to service its financing costs (Interest Cover ratio).

Further more, the structure of the assets and liabilities of a company can be seen.  How many of the company's assets are tangible or intangible, how much cash does it have, how many of its liabilities and assets are short-term in nature or non-current, and how many of the values shown are at fair value, estimated value/cost (e.g. provisions), and historical cost.

The income statement reveals how profitable a company has been in the short-term and, as accounting standards move more towards a fair value basis of accounting, the net profit figure is becoming less and less relevant and merely a balancing figure.  Despite this, revenues, gross profit margin, and operating expenses are all significant performance measures of a company's ability to generate returns.

Stripping out fair value adjustments and once-off profits and/or losses, the income statement can be distilled down to its core performance, which in theory, should equal "headline earnings".  This number indicates the company's true profitability and, when comparing it with prior years headline earnings, often serves as a good indication of a company's true growth rate.

Still, looking at either the balance sheet or the income statement for investment purposes is too one-sided.  Rather, the interaction between the two and the company's share price is the trick to making informed investment decisions.

Having settled on researching a company, have a look at the company's Price Earnings (incomes statement-share price), the Price Earnings Growth (income statement-share price), the share price / TNAV or NAV (balance sheet-share price), the Return on Equity (income statement-balance sheet), the Return on Assets (income statement-balance sheet).

Come to a conclusion on how sustainable profits are with regards to the quality of the company's underlying asset base.  In other words, are profits year-on-year volatile with significant amount of intangible assets...or is the Return on Assets steady (and hopefully growing).

In bull markets the emphasis falls mostly on the income statement, as the optimistic mood in the market is expecting high future profits. Contrary to this, in bear markets the emphasis tends to be placed on the balance sheet with strength of liquidity and low debt providing a buffer against rising interest rates and/or slipping demand.

Despite both of these views, the balance sheet and income statement are both equally important in assessing a company and neither should be viewed in isolation.

Related to both the income statement and the balance sheet (and possibly more important) is the cash flow statement.  The report shows the actual cash generated, spent and retained by the company and breaks it down into various classes for analysis.

Many feel that the cash flow statement is a true reflection of a company's performance.  The argument is that accounting profits can be manipulated by the adoption of different accounting policies and estimates, while the physical amount of cash in bank at year end is harder to manipulate.

Overall, each of the three major components of the financial statements of companies (balance sheet, income statement, and cash flow statement) cannot be viewed in isolation.  The sum total of the strengths, weaknesses and trends in these statements and their interaction with each other should be understood and used in analyzing a company.

Two good links for reading:

Daily MarketResearchArchive

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