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Balance sheet and income statement relationship

Balance Sheet and Income Statement Relationship. Created by Sal Khan.

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Video transcript

Let's see if we can use our example to understand the three types of income statements, and hopefully understanding those income statements will also help us understand this example. So I'm going to start off-- we're going to focus on month two. And what I have done is I've just rewritten some of this accrual income statement down here. So it really looks like a statement. So this right here is the income statement for month two on an accrual basis. In that month, we said we had $400 of revenue, $200 of expense. 400 minus 200 gives us $200 of income. An income statement tells us what happened over a period of time. What was the activity-- how much revenue, how much expenses, and other things. This is just a super simplified one without taxes, without interest, without other types of expenses over here. I also have drawn the balance sheet at the end of month one and the balance sheet at the end of month two. Or you could also view this balance sheet here as the balance sheet at the beginning of month two. And the main thing to realize is income statement tells you what happens over a time period, while balance sheets are snapshots, or they're pictures at a given moment-- snapshots. So this tells us essentially what did I have. The assets are the things that can give me future benefit, so what do I have. And the liabilities are things that I have to give future benefit to, or things that I owe. So this is what I have. This is what I owe. And then the equity is what I really have to my name if I net out the liabilities from the assets. So at the beginning of month two-- which is the end of month one-- I had $100 of cash, no accounts receivables. I didn't owe anyone anything. I didn't owe them money. I didn't owe them services. So 100 minus 0 means I had $100. That's kind of what the owners of the company can say they have of value at the beginning of the month. You fast forward-- now at the end of month two-- I now owe the bank $100. So I just put this as negative $100 here. It normally wouldn't be accounted that way on an actual company's balance sheet, but this is simplified. But I have an accounts receivable of $400. So my total assets now are $300 of assets. And remember, accounts receivables are an asset because someone owes me something. Someone owes me cash in the future. I still have no liabilities. So you take all of your assets, minus all of your liabilities, and now I have $300 in equity. So you can see the snapshot at the beginning of the month, 100 in equity. Snapshot at the end of the month, 300 in equity. And so to go from one point to the other, to go from 100 to 300, I must have grown in equity by 200. I must have gotten $200 worth of value from someplace. And that's what the income statement describes. It describes it right over here. The change in equity, sometimes it's the change in returned earnings or just change in equity. That is going to be the $200 in net income that the company got over that time period. Now, there's one thing that you're probably confused by right now. It's like, well, how do we reconcile everything with the cash? We know that over this period we got $200 in income on an accrual basis. But when you look at the cash, we went from $100 positive cash, to negative $100 in cash. It looks like we lost $200. So how can we reconcile the fact that we got $200 in income? How can we reconcile that with the fact that we lost $200 in cash? And that reconciliation is going to be done on the cash flow statement. And I'll do that in the next video.