Understanding how the balance sheet and income statement interrelate will give you a better understanding of accounting, along with new tools for analyzing investments. One key topic to understand is the relationship between the balance sheet and the income statement; more specifically, how the net loss or earnings amount is transferred over to retained earnings.
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Income Statement & Balance Sheet
The income statement shows how much money a company made during a period of time, while the balance sheet shows the company's financial position. The stockholder's equity section has two parts -- contributed capital and retained earnings. Contributed capital is what owners have contributed to the company, while retained earnings are what the company has earned and reinvested in itself.
Impact on Retained Earnings
Retained earnings keep track of the cumulative net income for the company since inception. Once the income statement is completed, the earnings figure from the time period is transferred to retained earnings in the stockholder's equity section of the balance sheet. A net loss reduces retained earnings; a net gain increases retained earnings.
Dividends & Retained Earnings
Retained earnings can fall even when the earnings figure is positive. If a company pays out more in dividends than it earned during the year, the retained earnings of the company will fall. Furthermore, dividends are paid with cash, while earnings are an accounting metric for profits. A company can pay out more in dividends than it earns if the accounting income does not match up with the cash flow.
Analyzing Retained Earnings
Taking a quick look at retained earnings will give you an idea of how successful the company has been since inception. A high retained earnings figure is a positive sign; it is an indication that the company has been very successful. Success brings other benefits, such as the company's ability to buy back shares and pay dividends. A low retained earnings figure may indicate the company hasn't been very successful since inception, and there probably isn't a lot of money available for dividends and share repurchases.