How the Two Statements Relate to Each Other
Chapter Nine
Syllabus topic 3, "Study of Balance sheet and Income statement / Revenue statements in vertical form suitable for analysis ii. Relationship between items in Balance Sheet and Revenue statement iii. Tools of analysis of Financial Statements (i) Trend analysis (ii) Comparative Statement (iii) Common Size Statement"
Pages 19 to 21 of 162
In one line
The balance sheet holds the resources; the revenue statement shows what those resources produced; and a combined ratio measures the second against the first.
The relationship in one sentence
The balance sheet is a photograph and the revenue statement is the film. The photograph at 31 March 2026 and the photograph at 31 March 2027 differ, and the revenue statement for the year between them explains most of the difference.
Proof, from the running example.
| Rs | |
|---|---|
| Reserves and surplus at 31 March 2026 | 1,40,000 |
| Add: profit after tax for the year | 2,38,000 |
| Less: preference dividend | (18,000) |
| Less: equity dividend | (60,000) |
| Reserves and surplus at 31 March 2027 | 3,00,000 |
The revenue statement moved the balance sheet. That is the relationship in its purest form, and every other pairing below is a variation on it.
The pairings that matter
| Balance sheet item | Revenue statement item | The relationship |
|---|---|---|
| Capital employed | Profit before interest and tax | The capital was put in to earn this; return on capital employed |
| Proprietors' funds | Profit after tax | The owners' money earned this; return on proprietors' fund |
| Equity shareholders' funds | Profit after tax less preference dividend | Return on equity capital |
| Stock | Cost of goods sold | Stock was bought to be sold; stock turnover ratio |
| Debtors | Credit sales | Debtors arose out of sales; debtors turnover |
| Creditors | Credit purchases | Creditors arose out of purchases; creditors turnover |
| Long-term debt | Interest | The debt costs this; debt service ratio |
| Fixed assets | Net sales | The assets produced the sales; fixed assets turnover |
| Reserves and surplus | Retained profit | The reserve IS the accumulated retained profit |
Nine pairings, and six of them are ratios MU names. Learn the middle column against the left and Module III's combined ratios stop needing to be memorised.
Why one is a flow and the other a stock
This is the point that makes averages necessary.
| Balance sheet | Revenue statement | |
|---|---|---|
| What it is | A stock, at a moment | A flow, over a period |
| Sunrise's stock figure | Rs 3,00,000 on 31 March 2027 | |
| Sunrise's cost of goods sold | Rs 14,00,000 during the year |
Dividing a whole year's flow by one day's stock compares unlike things. So where a ratio pairs a flow with a stock, the stock is taken as an average of the opening and closing figures wherever the question gives both.
| Rs | |
|---|---|
| Stock at 31 March 2026 | 2,60,000 |
| Stock at 31 March 2027 | 3,00,000 |
| Average stock | 2,80,000 |
Stock turnover is therefore Rs 14,00,000 over Rs 2,80,000, which is 5 times, not Rs 14,00,000 over Rs 3,00,000.
The same applies to debtors and to creditors. It does NOT apply to the current ratio or the proprietary ratio, because both of their elements are stocks and both are taken at the same date.
How the Two Statements Relate to Each Other
The rule, stated once
| The ratio pairs | Take the balance sheet figure as |
|---|---|
| A flow with a stock, e.g. sales with debtors | The average of opening and closing, if both are given |
| A stock with a stock, e.g. current assets with current liabilities | The closing figure |
| A flow with a flow, e.g. gross profit with sales | Not applicable; both are flows |
And where only the closing figure is given, use it and say so. An examiner gives one figure when he intends it to be used.
Two relationships that are NOT ratios
Depreciation and fixed assets. The revenue statement's depreciation charge reduced the balance sheet's fixed assets, so they are related, but no ratio in MU's list divides one by the other.
Provision for tax. It appears in the revenue statement as a charge and in the balance sheet as a current liability, and the two are the same amount in the year it is created. Notice that in Sunrise: Rs 1,02,000 in both places for 2027, which is a check worth running.
Where the relationship breaks
A ratio can be arithmetically correct and meaningless. Three cases:
- The stock figure is not typical. A firm that counts stock just after its selling season has an unrepresentative closing stock, and the turnover ratio flatters it.
- Sales are seasonal. A year's sales against a debtors figure taken at the quietest month understates the collection period badly.
- An item changed its nature during the year. An investment reclassified from non-current to current changes the current ratio without anything happening in the business.
Say which of these applies when a question asks you to comment, because it is the difference between analysis and interpretation.
Quick revision
| The core relationship | Retained profit moves reserves; the revenue statement moves the balance sheet |
| Six named pairings | Capital employed with PBIT; proprietors' funds with PAT; equity funds with PAT less preference dividend; stock with cost of goods sold; debtors with credit sales; creditors with credit purchases |
| Stock and flow | The balance sheet is a stock, the revenue statement a flow |
| When to average | When a ratio pairs a flow with a stock, and both dates are given |
| When not to | When both elements are stocks, as in the current ratio |
Test yourself
- Prove that the revenue statement moved Sunrise's reserves.
- Why is stock turnover computed on average stock?
- Should the current ratio use average current assets?
- Which revenue statement figure pairs with capital employed, and why that one?
- Give one reason a correctly computed turnover ratio can still mislead.
Answer in one sentence
1. Reserves of Rs 1,40,000 plus profit after tax of Rs 2,38,000, less preference dividend Rs 18,000 and equity dividend Rs 60,000, gives Rs 3,00,000, which is the closing figure.
How the Two Statements Relate to Each Other
2. Because cost of goods sold is a flow over the whole year while stock is a figure at one date, and averaging the opening and closing stock makes the two comparable.
3. No, because both current assets and current liabilities are stocks taken at the same date, so there is nothing to make comparable.
4. Profit before interest and tax, because capital employed includes the lenders' money and the reward of that money is the interest, which must therefore not yet be deducted.
5. The stock counted at the year end may be untypical of the year, for example just after a selling season, which flatters the turnover.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.