How are the three Financial Statements Linked?
The three financial statements are the Income Statement (IS), Balance Sheet (BS), and Cash Flow Statement (CFS). Understanding the links between them is important for building models, and is a classic interview question in financial services.
So how to understand the links? Firstly, the IS lists sales for a period. But not all of them are cash sales. So the CFS takes the IS non-cash flows and converts them into cash flows. This difference in preparation – the IS is not prepared on a cash basis, but the CFS is – creates many links between the 2 statements.
Secondly, the BS tells us the company’s assets, liabilities, and equity, and again is prepared using differing accounting principles to the IS and CFS. In its most simple form, the CFS goes looking for cash flow changes in the BS, and the IS explains some of the changes in the BS. To go through every link would fill a library of books (we’d love to do this), but here we shortlist the major links.
Key Learning Points
The major links in the three financial statements are:
- Net income from the IS links to the BS (retained earnings) and the CFS operating section
- Property, plant and equipment in the BS creates depreciation in the IS and the CFS operating section, and also creates capital expenditure in the CFS investing section
- Changes in current assets and liabilities from the BS are aggregated to calculate Operating Working Capital (OWC) in the CFS operating section.
- Debt in the BS leads to interest expense in the IS, and debt issuance/repayment in the CFS financing section
- Ending cash in the CFS is what drives cash in the BS
Why Analyze Financial Statements
Net Income and Depreciation
The IS reports all sales and costs for the period, but not all of them are cash flows. So the first line in a CFS is net income from the IS, and then the CFS adjusts it to create cash flows. The best example of this adjustment is depreciation. Depreciation is a cost in the IS, but it is not a real cash flow, so the CFS adds it back to net income to pretend it didn’t happen.
Net Income and Retained Earnings
Net income can be paid out as dividends to shareholders, but can also be retained and kept by company. This retained net income is still owed to equity shareholders (“hey, where did my dividends go?”), so it goes in retained earnings in the equity section of the BS.
PP&E, capex and depreciation
PP&E (property, plant and equipment) is an asset in the BS, but as it is used up during the period it depreciates, and that depreciation cost goes in the IS.
Also, as PP&E goes up on the BS due to capex (capital expenditure), that capex is also a cash flow, which appears in the CFS.
Operating Working Capital
The CFS goes looking for any cash flows it can find in the IS and BS. Changes in OWC in the BS are one of those cash flows. If inventory goes up on the BS, cash goes out on the CFS. If accounts receivable goes down on the BS, cash comes in from customers on the CFS. These are summed up as “Changes in OWC” on the CFS.
Debt
Debt is on the BS, and companies have to pay interest on that debt. This interest cost goes on the IS.
Also, as debt is issued or repaid, the cash in or out flow appears in the CFS.
Cash
The CFS sums up all cash in and out flows for the year, and calculates the ending cash figure. This then goes in the assets section of the BS.
Free Download
The free download shows a three-statement financial model with the links between the statements color-coded for ease of reference.
Additional Resources
Balancing a Three-Statement Model
Debt Schedule
Investment Banking Courses
FAQs
Net income from the bottom of the income statement links to the balance sheet and cash flow statement. On the balance sheet, it feeds into retained earnings and on the cash flow statement, it is the starting point for the cash from operations section.
How do you link the three financial statements? ›
Net income from the bottom of the income statement links to the balance sheet and cash flow statement. On the balance sheet, it feeds into retained earnings and on the cash flow statement, it is the starting point for the cash from operations section.
What is the 3 financial statement exercise? ›
In a 3-statement model, you input the historical versions of these statements and then project them over a ~5-year period. In real life, you do this to value companies, model transactions, and determine whether the company's expected growth, margins, and cash flow metrics are plausible.
What are the three 3 standard financial statements and describe how they relate to one another? ›
The income statement illustrates the profitability of a company under accrual accounting rules. The balance sheet shows a company's assets, liabilities, and shareholders' equity at a particular point in time. The cash flow statement shows cash movements from operating, investing, and financing activities.
How do you combine financial statements? ›
Combining financial statements requires the aggregation of assets, liabilities, equity, revenues, and expenses from each reporting entity. The consolidated financial statements should reflect the parent company's ownership interest in the subsidiaries, and non-controlling interests should be separately disclosed.
How are the three financial statements linked in Quizlet? ›
How are the three financial statements linked? The Income Statement is linked to the Balance Sheet and Statement of Cash Flows through Net Income. Net Income flows to the Balance Sheet through the Retained Earnings account within Shareholders' Equity.
What are the three most important financial statements according to this resource link? ›
The three main types of financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements together show the assets and liabilities of a business, its revenues, and costs, as well as its cash flows from operating, investing, and financing activities.
How are the balance sheet and income statement connected? ›
The balance sheet shows the cumulative effect of the income statement over time. It is just like your bank balance. Your bank balance is the sum of all the deposits and withdrawals you have made. When the company earns money and keeps it, it gets added to the balance sheet.
How to prepare financial statements with examples? ›
The 9 steps in preparing financial statements are:
- Identify all business transactions for the period.
- Record transactions in a general journal.
- Resolve anomalies and make adjusting journal entries.
- Post the adjusted journal entries to the general ledger.
- Prepare an income statement.
- Prepare a balance sheet.
The cash flow statement shows the cash inflows and outflows for a company during a period. In other words, the balance sheet shows the assets and liabilities that result, in part, from the activities on the cash flow statement.
Retained Earnings are reported on the balance sheet under the shareholder's equity section at the end of each accounting period.
What are the three uses of financial statements? ›
To serve as a financial foundation for tax assessments. To provide valuable data for foreseeing the company's future earning capacity. To provide accurate information on the fluctuation of economic resources. To offer information on the organisation's net resource changes.
What are the three 3 main components of the statement of financial position describe each component? ›
The three main components of the statement of financial position are assets, liabilities, and equity, which are broken down into various categories. However, the way in which the statement is presented varies from company to company, depending on the types of assets, liabilities, and equity they have.
Why consolidate financial statements? ›
Consolidated financial statements give a high-level overview of the company's financial performance. This is essential information for management teams, shareholders, investors, lenders and financial journalists.
Can financial statements be combined and consolidated? ›
If you have multiple businesses that operate under the same LLC or corporation, you need consolidated or combined financial statements. For example, if you own a plumbing company and a plumbing supply shop, you may need either a consolidated or combined financial statement.
When can you consolidate financial statements? ›
Consolidated financial statements are used when the parent company holds a majority stake by controlling more than 50% of the subsidiary business. Parent companies that hold more than 20% qualify to use consolidated accounting.
What is the link between cash flow statement and balance sheet? ›
The cash flow statement shows the cash inflows and outflows for a company during a period. In other words, the balance sheet shows the assets and liabilities that result, in part, from the activities on the cash flow statement.
How do the four basic financial statements work together? ›
All four accounting financial statements accurately portray the company's overall financial situation. The income statement records all revenues and expenses. The balance sheet provides information about assets and liabilities. The cash flow statement shows how cash moves in and out of the business.
What is the relationship between balance sheet and profit and loss account? ›
The profit and loss (P&L) account summarises a business' trading transactions - income, sales and expenditure - and the resulting profit or loss for a given period. The balance sheet, by comparison, provides a financial snapshot at a given moment.
