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The term “articulation” doesn’t really sound like an accounting term. However, understanding articulation is key to understanding accounting and dare I say the key to understanding business.

Yes, it is that important in business!

The quick answer to what is articulation, is that it is the interrelationship between the financial statements. However, that definition is overly simplistic and it creates more of a focus on the accounting financial reports than the deeper understanding of its implication to business overall.

To truly understand articulation, we should first get an overview of the basic financial statements. This includes the balance sheet, and income statement. A quick definition of each reveal that the balance sheet is a snapshot of a business’s value at a point in time. The quick definition of an income statement is it is profitability over a period of time.

Let’s start with the balance sheet. The balance sheet basically provides the assets of the organization and how much of that asset value is based on liabilities or equity. Assets are resources available to the management. The more resources available, the more opportunities management has to produce profit. You can think of the balance sheet as a way to show the potential of the business.

Consider a limousine service. If managers have 10 limos that implies a certain amount of potential for profit. A limo service with 20 vehicle provides managers more potential for profitability. The balance sheet will also show how that business acquired their assets. How much is based on debt versus investment money.

That brings us to profitability. Managers are given access to the assets of the business for the expressed reason to generate profits. The income statement shows the effectiveness of management to generate profits using the resources of the organization. One way that the two financial statements articulate is through that relationship. The assets provided on the balance sheet are resources used by management to generate profitability on the income statement.

We can dive deeper in understanding articulation. The net income that is generated will eventually produce cash that can be invested in more assets. More assets then offer more opportunity for profit. Effective managers can create a spiral upwards that results in growing the organization. The balance sheet can drive profitability. Profits can be reinvested into more assets that then drive more profits.

Of course, that is only in the case of effective management. If managements’ efforts result in losses, then assets will have to liquidated to cover operating cash needs which will leave less resources for future periods. That diminishes future potential. That results in a downward spiral.

One of the key ratios used to evaluate management’s effectiveness is the Return on Assets. Simply stated the net income is divided by the average total assets on the balance sheet. This results in a percentage that indicates how effective the managers have been. The bigger the return on assets the more effective the management. Return on Assets ratio really highlights the relationship between the balance sheet and income statement.

Understanding articulation is more than accounting jargon. Deeper understanding this concept offers an overview of the resources, potential, and results inherent in any business.

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