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Why the Income Statement Cannot Be Looked at Alone  

by
Julie Farless
on
9/13/2017
Why the Income Statement Cannot Be Looked at Alone  

The income statement remains one of the most misunderstood financial statements, and much of that confusion has to do with understanding the difference between leverage, cash flow and overall income.

The income statement shows the overall position of a company when it comes to revenue earned, expenses charged and the net balance, i.e., what's left over when everything, both spending and income, is accounted for. However, it should not be confused with cash in the bank. Too often people just look at an income statement and assume a business is healthy. That's because an income statement counts all revenue as income, whether it has been actually paid or not. So, for example, an accounts receivable could add to income and provide enough positive value that, after expenses, makes everything look good and in the black. However, in reality, the accounts receivable has not been paid, but the expenses have come due. So, in truth, the business is in the red with more expenses than money to pay them. This is why it is so important to look at both the income statement as well as the cash flow statement together.

A key aspect of the income statement is that it is based on an accrual method (versus cash basis) of reporting revenue earned. A primary example of accruing income is in sales. Revenue is posted and counted as soon as a sale is confirmed. However, as many small business owners are keenly aware, a sale is only as good as it is actually paid. So if payment is delayed or falls behind schedule, what looks like healthy revenue can actually be a situation in which the business is running down on an empty tank and there's nothing in the bank to pay the operating bills. Therefore, when making a decision on an income statement, it's important to have the cash flow statement handy as well.

The cash flow statement shows the actual money coming into the bank account versus the money going out. Pending amounts, such as accruals for accounts receivables or accounts payables, do not get counted in the cash flow statement, which is, literally, the true checkbook of the company. However, cash flow does not anticipate what may be withdrawing soon, and this is the shortcoming of looking at finances from a cash-only perspective. The income statement, conversely, is beneficial because it shows future transactions, whereas the cash flow statement can only operate in the present. The two together show both the immediate financial cash solvency of the business as well as what will come in the short-term period, i.e., over the next month or accounting cycle.

The third area of confusion is the balance statement. The value of the balance statement determines whether the company is running on its own assets, is highly leveraged on credit, or is sinking under liabilities. Because the income statement and cash flow statement can be fudged by an infusion of credit, viewers won't see leverage at play unless they see the balance statement figures as well. And vice versa, the user can't tell what's happening with a company's money flow from just looking at the balance sheet alone. The income statement must be considered in tandem to see whether assets and liabilities will change over time.

Therefore, none of the three financial statements should be considered independently. A smart financial viewer looks at all three to interpret the results of each individual report correctly. In some ways, considering the three statements in a micro-macro perspective helps; the balance sheet is the macro, big forest view, the cash flow statement is the micro/immediate view, and the income statement is between the two scaling back up or down.

The income statement can be valuable in seeing the expected net income of a business, but by itself, the document can be extremely misleading. It's not surprising that more than one stock trader has made bad decisions after looking at just an income statement and nothing else before a trade. And the same thing applies to business managers or owners who rely too heavily on expected paper income without watching for cash or credit liabilities creeping up.

Martinez & Shanken, PLLC writes for TaxBuzz, a tax news and advice website. Reach the firm at [email protected]

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Julie Farless

Julie Farless

Martinez & Shanken, PLLC is a Certified Public Accountant (CPA) firm based in Gilbert, Arizona. We provide a full range of accounting, bookkeeping, consulting, outsourcing and business services, but we specialize in tax preparation. We work with you to ensure that your personal or business processes are conducted in a manner that ensures ongoing integrity in your financial transactions. We are available to answer your questions and help with your ongoing tax planning and changing business needs.

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