A Period of Performance Against a Single Moment

The income statement shows how much a company earned or lost over a period, such as a quarter or a year. The balance sheet shows what the company owns, what it owes and what is left for shareholders on one specific date.

A simple way to picture the difference: the income statement is a video of the year’s business, while the balance sheet is a photograph taken at the end of it. Each answers a different question, and investors need both.

Advisers read these statements to judge whether a company’s shares or bonds suit a client. For the full route from the exam to a career making those judgments, our complete guide to how to become an investment adviser representative covers every step.

Turn the new year into exam momentum with the FRC Series 65 playlists on YouTube

What the Income Statement Shows

The income statement starts with revenue, the money earned from selling goods or services. It then subtracts the cost of goods sold, operating expenses, interest and taxes, step by step, until it reaches net income, often called the bottom line.

Along the way it shows several measures of profit. Gross profit is revenue minus the cost of goods sold, operating income is gross profit minus operating expenses, and net income is what remains after interest and taxes.

The statement ends with earnings per share, the net income available to common shareholders divided by the number of common shares outstanding. The Series 65 Exam Preparation course at FRC covers each line and how it feeds into valuation ratios.

What the Balance Sheet Shows

The balance sheet lists assets, liabilities and shareholders’ equity at a single point in time. It always follows the same equation: assets equal liabilities plus shareholders’ equity.

Assets are split into current assets, such as cash, receivables and inventory that are expected to turn into cash within a year, and long-term assets, such as property, equipment and intangible assets. Liabilities are split the same way, into current liabilities due within a year and long-term liabilities such as bonds.

Shareholders’ equity is what would be left for the owners if all assets were sold at their recorded values and all liabilities paid. It includes the money shareholders paid in for their shares and the retained earnings the company has kept over time.

Income Statement and Balance Sheet Compared

Worked Example: Building an Income Statement

A company reports revenue of $500 million and cost of goods sold of $300 million. Step one: gross profit is $500 million minus $300 million, or $200 million, a gross margin of 40 percent.

Step two: subtract operating expenses of $80 million to reach operating income of $120 million. Step three: subtract interest expense of $20 million, leaving pretax income of $100 million.

Step four: at a 21 percent tax rate, tax is $21 million, so net income is $79 million. Step five: with 50 million common shares and no preferred stock, earnings per share are $79 million divided by 50 million, or $1.58.

Worked Example: Reading the Balance Sheet

The same company reports total assets of $1,000 million, total liabilities of $600 million and shareholders’ equity of $400 million. Step one: check the equation, since $600 million plus $400 million equals $1,000 million.

Step two: current assets are $250 million and current liabilities are $125 million, so working capital is $125 million and the current ratio is 250 divided by 125, or 2.0. Step three: inventory is $90 million, so the quick ratio, which excludes inventory, is 250 minus 90, divided by 125, or 1.28.

Step four: long-term debt is $300 million, so the debt-to-equity ratio is 300 divided by 400, or 0.75. Step five: book value per share is $400 million divided by 50 million shares, or $8.

Study Financial Statements With FRC

Financial statement questions on the exam usually ask which statement shows a given item, how to calculate a ratio and what a ratio says about a company. Our Series 65 course works through each statement with numbers so the formulas become automatic.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

How the Two Statements Connect

The statements are linked through retained earnings. Net income from the income statement, minus any dividends paid, is added to retained earnings in shareholders’ equity on the balance sheet.

Worked example: the company earns $79 million and pays a dividend of $1 per share on 50 million shares, or $50 million. Step one: subtract the dividend from net income to get $29 million. Step two: retained earnings on the balance sheet rise by $29 million, so shareholders’ equity grows from one year-end to the next.

Dividends do not appear as an expense on the income statement. They are a distribution of profit to owners, which is why they reduce retained earnings directly instead of reducing net income.

Where the Cash Flow Statement Fits

Net income is not the same as cash. The income statement uses accrual accounting, recording revenue when it is earned and expenses when they are incurred, even if the cash moves later.

The cash flow statement bridges the gap by showing actual cash from operating, investing and financing activities. It starts with net income and adjusts for non-cash items such as depreciation and for changes in working capital.

Together the three statements give a complete picture. A company can report a profit and still run short of cash if customers pay slowly or it spends heavily on new equipment, a gap the cash flow statement reveals.

Valuation Ratios Built From Both Statements

Many of the ratios investors use combine figures from both statements. The price-to-earnings ratio divides the share price by earnings per share from the income statement, while the price-to-book ratio divides the share price by book value per share from the balance sheet.

Worked example: the company’s shares trade at $31.60. Step one: the P/E ratio is $31.60 divided by $1.58, or 20. Step two: the price-to-book ratio is $31.60 divided by $8, or 3.95.

Return on equity also combines the two, dividing net income by shareholders’ equity. Here that is $79 million divided by $400 million, or 19.75 percent, a measure of how much profit the company generates from the owners’ capital.

How Advisers Use the Statements for Stocks

Equity investors look mainly at the income statement for growth. Rising revenue, stable or improving margins and growing earnings per share over several years suggest a business that can support a higher share price.

Growth investors often accept high P/E ratios for companies with fast-rising earnings. Value investors look for low P/E or price-to-book ratios, sometimes finding companies whose balance sheets hold assets the market has overlooked.

Income investors focus on whether earnings comfortably cover the dividend. A company paying out more than it earns may have to cut the dividend later, which can be seen by comparing dividends with net income over time.

How Advisers Use the Statements for Bonds

Bond investors care most about whether the company can pay interest and repay principal, so the balance sheet carries more weight. High debt relative to equity, or weak current assets relative to current liabilities, can point to higher credit risk.

The income statement still matters, because interest is paid from operating income. Interest coverage, operating income divided by interest expense, shows how many times the company could pay its interest bill; here $120 million divided by $20 million gives a coverage of 6 times.

A falling coverage ratio or rising debt load is one of the warning signs that can lead to a credit downgrade. Our article on what happens when a bond is downgraded explains how that change affects bond prices and yields.

Where Investors Find the Statements

Public companies in the US file their financial statements with the Securities and Exchange Commission. The annual report on Form 10-K contains audited statements for the full year, while the quarterly report on Form 10-Q contains unaudited statements for each of the first three quarters.

Both filings include management’s discussion and analysis, where the company explains its results, and notes that describe accounting policies, debt terms and other details behind the numbers. Many of the most useful facts for an adviser, such as when debt matures, sit in those notes rather than on the face of the statements.

Companies also announce earnings before filing, and markets react to those announcements in the same way they react to economic data. The headline figures are compared with analysts’ expectations, so a profit that beats forecasts can lift the share price even if it is lower than the year before.

Comparing Companies and Spotting Trends

Raw dollar figures make it hard to compare a large company with a small one. Analysts often convert the income statement into percentages of revenue and the balance sheet into percentages of total assets, a method known as common-size analysis.

Worked example: the company’s operating income of $120 million on revenue of $500 million gives an operating margin of 24 percent. A competitor with operating income of $30 million on revenue of $200 million has a margin of 15 percent, so the first company is more profitable per dollar of sales even before considering size.

Trend analysis compares the same company over several years. A margin that slips from 24 percent to 20 percent to 16 percent tells an adviser more than any single year’s figure, and prompts questions about competition, costs or pricing.

Limits of the Statements

Financial statements report the past, and markets price the future. A strong income statement last year does not guarantee strong results next year, especially in cyclical industries.

Balance sheet values are mostly recorded at historical cost less depreciation, not at current market value. A building bought decades ago may be worth far more than its book value, while some intangible assets, such as a strong brand built internally, may not appear at all.

Companies also make accounting choices about revenue recognition, depreciation and inventory valuation that affect reported figures. Advisers compare companies within the same industry and read the notes to the statements rather than relying on a single headline number.

The Memory Aid

Remember “video versus photo”: the income statement covers a period, the balance sheet captures one date.

For the balance sheet, remember “A equals L plus E”: assets always equal liabilities plus shareholders’ equity.

For the link, remember “profit minus payout builds the base”: net income minus dividends adds to retained earnings on the balance sheet.

Exam Traps to Avoid

The first trap is placing dividends on the income statement as an expense. Dividends reduce retained earnings on the balance sheet; they are not an expense.

The second trap is assuming net income equals cash generated. Accrual accounting and non-cash items such as depreciation mean the two often differ, which is why the cash flow statement exists.

The third trap is calculating the quick ratio with inventory included. The quick ratio removes inventory from current assets because inventory can be slow to turn into cash. The fourth trap is forgetting that earnings per share use net income minus any preferred dividends, divided by common shares outstanding.

A Client Scenario

A client wants to buy shares in a company because its latest income statement shows record profits. The adviser looks at the balance sheet as well and finds that debt has tripled in two years and current liabilities now exceed current assets.

The adviser explains that the profits are real, but the company has borrowed heavily and may struggle to meet its short-term obligations if sales slow. The cash flow statement also shows operating cash flow falling below reported net income.

The client decides to take a smaller position than planned and diversify across other holdings. The adviser records the analysis and the client’s decision in the file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the income statement and balance sheet entries to see each line explained on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: Which statement shows a company’s assets and liabilities on a single date? The balance sheet.

Question two: A company has revenue of $200 million, cost of goods sold of $120 million and operating expenses of $30 million. What is operating income? $200 million minus $120 million minus $30 million, or $50 million.

Question three: Current assets are $90 million, inventory is $30 million and current liabilities are $40 million. What is the quick ratio? 90 minus 30 is 60, divided by 40, or 1.5.

Question four: A company earns $40 million and pays $15 million in dividends. By how much do retained earnings rise? $25 million.

Question five: Do cash dividends appear as an expense on the income statement? No; they reduce retained earnings.

Turn Financial Analysis Into Career Evidence

Clients often ask whether a company they have read about is a good investment, and an adviser who can read its statements gives an answer grounded in numbers. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Walking through how record profits can sit alongside a weakening balance sheet shows the analytical skill advisory firms look for.

Related Questions

Company-specific weaknesses revealed by a balance sheet are the kind of risk diversification can reduce, as our comparison of systematic vs unsystematic risk explains. To see how the earnings that drive P/E ratios react to the wider economy, read how economic indicators affect stock and bond prices.

Key Points to Retain

The income statement shows revenue, expenses and net income over a period, ending with earnings per share. The balance sheet shows assets, liabilities and shareholders’ equity on one date, and assets always equal liabilities plus equity.

Net income minus dividends flows into retained earnings, linking the two statements, while the cash flow statement shows the actual cash behind the profit. Advisers use the income statement mainly to judge profitability and growth, and the balance sheet mainly to judge liquidity and financial strength.

For the role the exam leads to, read our guide to what an investment advisor representative is.