Welcome, I find that people often ask me, what's your favorite financial statement, the income statement or the balance sheet? They're trying to figure out, well, which one of these really is better so that I can just focus on knowing it. That's kind of like asking me, which one of my kids do I love more? Well, maybe it's more like asking me, do I prefer salt or sugar? It really depends on the situation. If we're going to talk about the income statement versus the balance sheet, why don't we start with how are they the same? The biggest way that they're the same is that they both use accrual accounting. That's that concept where we're trying to capture what really has occurred economically, rather than just focusing on cash. We're really trying to get the reality of what's occurred this period, and where we stand right now. The other major similarity between them is they both answer one of the two big questions in life. Now, that's the way they're similar, but that also gives us their jumping off point for how they're different. The balance sheet gives us this snapshot in time. So we're going to use it when we think of questions like, how much are we owed by customers? Or how much inventory do we keep in stock? Or how much do I owe my suppliers? Each one of those is telling us something about where we are at in a specific point in time. The income statement answers that second big question, what happened this period? So if we ask a question like how many sales did we make? Or what did it cost us to make those sales? Or how much interest did I incur this year? In all of those situations, we're going to look at the income statement to try to figure out what happened this period. Now, sometimes you might forget which statement does which for me. The nice thing about the statements is they actually remind you. If you were to take a look at Royal Bank of Scotland's balance sheet, you'd see that right on top of it it says, Consolidated balance sheet as of 31 December 2016. Or what about MTM Group, that's one of the largest mobile providers in Africa, and their's say, Group statement of financial position at 31 December 2016. Notice, both of these are pointing out they're at a specific point in time. That's answering that balance sheet question of where do we stand right now. Now, you also might have noticed that MTM Group actually doesn't call it a balance sheet. They call it a statement of financial position. But because they're telling you it's capturing at a certain point in time, you know that it's answering that first big question in life, where do we stand? And usually we would call that a balance sheet. What about the income statement? Does it remind us as well? If you look at HSBC, the big British bank's financial statements, you'll see on the top of their income statement they say, Consolidated income statement for the year ended 31 December. And if you look at TOTAL, the big French oil company, you're going to see that even though it's European instead of a British firm, it still is going to say the same thing, consolidated income statement for the year ended 31 December. If we were looking at US firms, the only difference you would see is it would say, for the year ended December 31st instead. It's still going to remind you, this is the purpose of this statement. Now sometimes, you're not just going to answer, one of the big questions in life. You're actually going to want to combine those two big questions. Where are we in a point in time, as well as what's happened over time? For example, what if somebody said to you, did this manager make good use of the investments that the owners have put into the firm? Well, you'd need to know two things then, you need to know what value was created over the time period. This is giving us that what happened over a certain period? You'd also need to know what did the manager have during that period? Or another way to think of that is, what was it that the owners had actually invested, and let the manager have use of? That's going to be a snapshot. So we can combine information from these two statements to make something we call a ratio. In this case, we do something we call return on equity. We're going to take net Income, that's off the income statement, and it tells us something about what's happened over time, and we're going to divide that through by equity, which is off the balance sheet that tells us how much had the owners given the manager to use during this time period. Now, we've got an entire set of videos on ratios, and we'll get into those in a lot more detail. But it's important for you to understand from the beginning that really what a ratio's doing is still answering one of those two big questions. Which means it's going to draw from the financial statements depending on whether it's answering the first big question, the second big question or something that's a combination of the two. I hope this video has helped you understand that both balance sheet and income statement are important. And the one that's most important really depends on what it is you are trying to achieve in a given situation. Now, before I leave that behind, I do want to talk about something that I've noticed over time. It seems like it's a lot harder for students to really get comfortable with the income statement. I was a little surprised about this when I first started teaching, but then I realized that was true for me too. Eventually, I went over to speak with some of my colleagues, who studied neuroscience, the way your brain works, as well as some colleagues who were psychologists. They told me that our brains actually have a very hard time with this concept of time. In fact, scientists don't exactly know how our brains capture time even now. So it's not surprising that trying to think of things unfolding over time are more difficult for us, that's actually the way everybody's brain works, not just yours. Since I learned that, I've tried to think about a way to make this a little easier for people. Since I know that people naturally tend to think more in the balance sheet method, I've started to think of this analogy of the flip chart like you had when you were a kid. You'd draw a bunch of pictures and as you flipped it, the pictures would become clearer to you. Well, if you think of the picture I'm showing you here, each one of these individual flips is telling us something about a point in time. But by putting all of those together, we're getting some sense of how this tree changed over time. If it's easier for you with the income statement you can think of it being made up of a whole bunch of individual snapshots in time that are added together to give us this flow, this sense of time occurring. I hope that this helps you feel more comfortable with using the income statement as well.
