The following demonstrates how the Balance Sheet interacts with Profit and Loss:
- When a cash sale is made (recorded in Profit and Loss), the cash in hand will increase (Balance Sheet item).
- When staff salaries were paid (impacting the Profit and Loss), the cash at bank will reduce (Balance Sheet item).
- When the inventories (in the Balance Sheet) is used up to make a sale, the Cost of sales (in the Profit and Loss) will increase to capture the cost incurred.
- What is left after deducting all the costs from the income will be the net profit (in the Profit and Loss) and this belongs to the shareholders and therefore recorded as Retained earnings in the Balance Sheet.
The formula for retained earnings is RE 1 = RE 0 + NI – D
RE 1 – net income at the end of the reporting period
RE 0 – net income at the beginning of the period
NI – net income minus income tax
D – Dividends paid