Which statement best describes the relationship between the income statement and shareholders' equity?

The relationship between the income statement and shareholders' equity is primarily illustrated through retained earnings, which are directly influenced by net income. When a company generates net income, a portion of that income is typically retained within the company rather than distributed as dividends. This retained income increases the retained earnings component of shareholders' equity on the balance sheet.

Retained earnings represent cumulative net income that has not been distributed to shareholders as dividends. Therefore, the net income reported on the income statement for any given period directly contributes to the growth of shareholders' equity by increasing retained earnings. This reflects the company's ability to reinvest profits back into the business, which can be used for expansion, paying off debt, or other corporate activities.

Understanding this relationship is crucial for analyzing a company's financial health, as an increase in retained earnings suggests a profitable operation and may indicate good management practices, which are favorable to investors and stakeholders.