Any organization dealing in business activities would broadly/roughly be called as a business enterprise. In order for a business enterprise to carry on business activities, it needs funds, which are typically provided by its owners in the form of owners’ equity. Such funds would be deployed in the business, by investing in various assets, which would then be utilized towards carrying out business activities. The revenue that is generated from such business activities would be used to calculate the valuation of the business.

Before we understand how this operates, we need to understand financial statements of a business organization, viz., balance sheet and the income statement. Balance sheet is a positional document presenting the status of assets and liabilities of the business on a particular date, while the income statement is the summary of the operations (business activities) of the business over a period of time, presenting incomes, expenditures, and the final status of carrying out such operations. There are many formats that are in use to present the balance sheet and the income statement, including the ones mandated by the statute. For the sake of understanding, we would be using the horizontal model for the balance sheet, and the vertical model for the income statement, which are intuitive in understanding.

Let us take a hypothetical example to explore how the two statements interact with each other.

• When owners invest capital into the business, they would be transferring the ownership of their cash or bank balances into the name of the business. On the date of such transfer, the status of the balance sheet would look something like Figure.1

Liabilities		Assets
Owners’ Equity	=	Cash / Bank Balance

Figure 1: A simplified Balance Sheet format

• Once the business has access to cash / bank balance, it would deploy it towards owning various assets of the business, such as fixed assets, current assets, and other assets. These assets are broadly classified as tangible assets (which includes land, building, vehicles, machinery, stocks / inventory, technology equipment, etc.), intangible assets (including computer software, mining rights and other licenses, goodwill, brands, customer lists, marketing program, contracts, research programme, etc.), intellectual property (including trademarks, copyright, patents, recipes, formulae, models, designs & prototypes, licenses & franchises, trade secrets & know-how, etc.) and monetary assets (including inventory, current investments, trade receivables, cash & bank balance, short-term loans & advances, etc.). Considering these transactions, the balance sheet of the business enterprise would look as presented in Figure 2.

Liabilities		Assets
Owners’ Equity		Tangible Assets
		Plus
Plus		Intangible Assets
		Plus
Long-term liabilities		Intellectual Property Rights
Plus		Plus
Short-term liabilities		Monetary Assets
Equals		Equals
Total Liabilities and Net Worth	=	Total Assets

Figure 2: A simplified balance sheet with all the components of the balance sheet

As shown in figure 2, generally speaking the assets must equal to the total of the liabilities. This is because, the financial resources that have been raised through owners’ equity and the borrowings can only be invested towards various assets that can be owned by the business.

• Having acquired the assets, the business enterprise has to deploy them in business activities to generate value for the stakeholders. For instance, the tangible assets like land and building have to be used to house machinery, stocks, tools, staff, and other offices; machinery has to be used to manufacture goods. Similarly intangible assets like computers have to be used for providing services including accounting, bookkeeping, etc.; brands and goodwill have to be used to earn profits higher than that of the competitors; contracts and licenses have been used to generate business opportunities that are not otherwise available to others without such rights and so on. Intellectual property rights like patents, designs & know-how have to be integrated into the production process and the design of the product, while trademark and copyright would embellish the product on the outside making a statement about the source and the quality of such products to the consumers.

While these assets contribute to the revenues of the business enterprise, the liabilities contribute to the costs associated with running the business organization. For instance, the bank loans have an interest obligation that needs to be paid to the bank, the debentures & corporate bonds have coupon interest rate to be paid to the investors; financial leasing would have leasing charges payable to the lessor; overdrafts and trade credit has interest charges to the organization, which would all contribute to the cost of sale of the goods and services finalized by the business organization.

The surplus of revenues over the cost of sales would be gross profit (if the cost of sales exceeds revenues, then it would be gross loss), from which operating expenses (in the nature of administrative and marketing expenses) would be deducted, resulting in operating profits or operating losses. From these operating profits / losses, incomes taxes would be deducted (only if there are operating profits), and the balance would be net profit or net loss.

net profit / net loss typically belongs to the shareholders of the business. The net profit is distributed to the shareholders in the form of dividends or retained in the business as retained earnings, which could be used for future growth of the business. However, the net loss reduces the owners’ equity (technically by wiping out their equity to the extent of the losses) or it could also reduce the balance of the retained earnings.

A summary of these transactions is presented in a statement called as “Income Statement”, which is presented for a certain period of time, usually one quarter or a half-year or one full financial year. A summary of these transactions is presented in the combined balance sheet and abridged income statement in Figure 3 below. The income statement is inserted between the asset side and the liabilities side of the balance sheet, just to make things simple to understand the relationship between various items in the balance sheet and the income statement.