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.
What is the link between the three financial statements? ›
The concept of retained earnings is the centerpiece that links the three financial statements together. The retained earnings balance in the current period is equal to the prior period's retained earnings balance plus net income minus any dividends issued to shareholders in the current period.
What are the example of three financial statements? ›
The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.
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.
What is the 3 statement model linking? ›
A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model.
How to link income statement and cash flow? ›
The cash flow statement is linked to the income statement by net profit or net burn, which is the first line item of the cash flow statement. The profit or loss on the income statement is then used to calculate cash flow from operations. This is referred to as the indirect method.
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.
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.
What is the most important of the three financial statements? ›
A financial statement segments into three divisions; Balance sheet, income statement, and cash flow statement. Among these 3 major financial statements, the most important financial statement is the income statement.
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.
What are the 3 financial statements in Excel? ›
In this video you will learn to build a fully functional and dynamic three-statement financial model in Excel. A three-statement model links the income statement, the balance sheet and the cash flow statement of a company, providing a dynamic framework to help evaluate different scenarios.
How to connect the three financial statements? ›
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.
A three-statement financial model, also called the 3 statement model is an integrated model that forecasts an organization's income statements, balance sheets and cash flow statements. It is the foundation on which we can build additional (and more advanced) models.
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.
How are balance sheet and cash flow statement related? ›
The balance sheet shows a snapshot of the assets and liabilities for the period, but it does not show the company's activity during the period, such as revenue, expenses, nor the amount of cash spent. The cash activities are instead, recorded on the cash flow statement.
