Understanding the Difference Between a Balance Sheet and Cash Flow Statement

A company’s financial statements provide investors and creditors with important information about its financial position and performance. The balance sheet and cash flow statement are two of the most common financial statements that companies issue. While both provide valuable insights, they differ in what they measure and how they are used for financial analysis. This article will explain in simple terms the key differences between a balance sheet and cash flow statement.

What is a Balance Sheet?

A balance sheet provides a snapshot of a company’s financial position at a specific point in time. It lists the company’s assets, liabilities, and shareholders’ equity as of a particular date, typically the end of a quarter or fiscal year.

The balance sheet gets its name from the fact that assets must equal liabilities plus shareholders’ equity Here is the balance sheet equation

Assets = Liabilities + Shareholders’ Equity

This means that all assets the company owns are funded by some combination of liabilities and equity. Liabilities represent debts or obligations that must be paid at some point in the future. Equity represents the amount invested by shareholders plus retained earnings.

Below are some of the key accounts you’ll find on a company’s balance sheet:

Assets

• Cash and cash equivalents
• Accounts receivable
• Inventory
• Property, plant and equipment
• Intangible assets like patents or trademarks

Liabilities

• Accounts payable
• Short-term and long-term debt
• Accrued liabilities like wages payable

Shareholders’ Equity

• Common stock
• Retained earnings
• Treasury stock

Analyzing the balance sheet helps investors understand the company’s financial flexibility based on its asset mix leverage and solvency. Creditors use it to evaluate the company’s ability to repay its debts.

What is a Cash Flow Statement?

While a balance sheet shows a snapshot at a point in time, the cash flow statement details the actual cash inflows and outflows over a period of time. This makes it useful for assessing a company’s liquidity and ability to generate cash.

The cash flow statement is divided into three sections:

• Operating activities – This includes cash generated from day-to-day business operations and shows if the company can produce enough cash flow to maintain operations without external financing. Cash flows from operating activities are generally the most important.

• Investing activities – These account for cash used for capital expenditures, investments, and acquisitions. Outflows in this section represent investments in the company’s future growth.

• Financing activities – This section covers cash flows from financing the business, including borrowing and repaying debt, issuing and repurchasing stock, and paying dividends.

Positive cash flow indicates the company generated more cash than it used, while negative cash flow means more cash was used than generated.

Major Differences Between the Balance Sheet and Cash Flow Statement

Now that we’ve covered the basics of the balance sheet and cash flow statement, let’s summarize some of the key differences between the two:

• Measurement type – The balance sheet shows account balances while the cash flow shows activities.

• Timeframe – The balance sheet is a snapshot at a point in time; the cash flow statement covers a period of time.

• Purpose – The balance sheet shows financial position; the cash flow statement shows liquidity.

• Flexibility – The balance sheet is highly structured and inflexible; companies have flexibility in how they present the cash flow statement.

• Accounts – The balance sheet shows account balances; the cash flow statement shows activities grouped into operating, investing and financing.

• Links to other statements – Changes on the balance sheet from one period to the next are linked to the income statement and cash flow statement.

• Mandatory – U.S. GAAP requires both statements; IFRS requires the balance sheet but the cash flow statement is recommended but not required.

How the Statements Interact

The balance sheet and income statement interact with each other and help explain items on the cash flow statement.

For example, net income from the income statement gets carried over to the cash flow statement. Changes in asset and liability balances on the balance sheet between two periods get reflected in the relevant sections of the cash flow statement.

The cash effects of investing and financing activities on the cash flow statement in turn impact asset and liability balances on the balance sheet. So while the balance sheet and cash flow statement differ in what they measure and when, they ultimately connect to tell the company’s financial story.

A Balance Sheet and Cash Flow Statement Example

Let’s look at a simplified example to see how the balance sheet and cash flow statement interact for a fictional company, XYZ Corp.

Here is the balance sheet for XYZ as of December 31, 2017:

|Assets| |Liabilities|
|-|-|-|-|
|Cash | $5,000 |Accounts Payable | $4,000 |
|Accounts Receivable | $3,000 | | |
|Inventory | $7,000 | | |
|Total Assets | $15,000 | | |
| | | | |
| |Shareholders’ Equity| | |
| |Common Stock | $6,000 | |
| |Retained Earnings | $5,000 | |
| |Total Liabilities & Equity | $15,000 | |

And here are the company’s 2018 income statement and cash flow statement:

Income Statement

Cash Flow Statement

Now let’s see how this flows through to the balance sheet:

• Net income of $10,000 increases retained earnings on the balance sheet.
• The increases in accounts receivable and inventory show up as increases in those asset accounts.
• The increase in accounts payable increases that liability account.
• The fixed asset purchase is not shown on the balance sheet since it already nets out on the cash flow statement to zero. Only the ending balances appear on the balance sheet.
• The dividend payment decreases retained earnings.

Putting it all together, here is the balance sheet as of December 31, 2018:

|Assets| |Liabilities|
|-|-|-|-|
|Cash | $5,000 | Accounts Payable | $5,000 |
|Accounts Receivable | $5,000 | | |
|Inventory | $8,000 | | |
|Total Assets | $18,000 | | |
| | | | |
| |Shareholders’ Equity| | |
| |Common Stock | $6,000 | |
| |Retained Earnings | $7,000 | |
| |Total Liabilities & Equity | $18,000 | |

This example demonstrates how the balance sheet account balances change over time based on transactions recorded on the cash flow and income statements. The statements complement each other to provide a comprehensive view of the company’s financial position and performance.

Analyzing both statements helps investors understand a company’s liquidity, solvency, operating efficiency and ability to create value over time. Both statements are crucial tools for making informed investment and lending decisions regarding a company. Just remember – the balance sheet shows financial position, while the cash flow statement shows financial performance.