How are the balance sheet and income statement linked?

The balance sheet and the income statement are linked primarily through retained earnings. Retained earnings represent the cumulative amount of profit that a company has retained, rather than distributed as dividends, since its inception. This figure is crucial because it reflects the company's financial performance over time, which directly impacts the equity section of the balance sheet.

When a company generates net income, this income is added to retained earnings on the balance sheet at the end of the accounting period. Conversely, if the company incurs a net loss, this amount would reduce retained earnings. This linkage ensures that the profits or losses reported on the income statement flow through to the equity of the company, demonstrating how the company’s operational effectiveness translates into overall financial position.

While cash flow management, operating expenses, and inventory management are all important aspects of financial analysis, they do not represent the direct connection between the balance sheet and income statement. These elements affect different parts of financial statements but do not establish the direct relationship that retained earnings do.