Linking Three Financial Statements - Example (2024)

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.

Linking Three Financial Statements - Example (1)

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.

Linking Three Financial Statements - Example (2)

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.

Linking Three Financial Statements - Example (3)

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.

Linking Three Financial Statements - Example (4)

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.

Linking Three Financial Statements - Example (5)

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.

Linking Three Financial Statements - Example (6)

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.

Linking Three Financial Statements - Example (7)

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

Linking Three Financial Statements - Example (2024)

FAQs

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 are the 3 main financial statements that you will need to be able to interpret in finance accounting? ›

The financial statements are used by investors, market analysts, and creditors to evaluate a company's financial health and earnings potential. The three major financial statement reports are the balance sheet, income statement, and statement of cash flows.

How do the three statements link together in an interview question? ›

Net income which is profit before tax less tax expense is connected on all three financial statements. Net income is located at the bottom of the income statement and directly at the top of the cash flow statement followed by cash from operations. On the balance sheet, net income feeds into retained earnings.

What is the 3 statement model linking? ›

What is a Three-Statement Model? A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model.

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.

Which 2 of the 3 financial statements is most important? ›

Another way of looking at the question is which two statements provide the most information? In that case, the best selection is the income statement and balance sheet, since the statement of cash flows can be constructed from these two documents.

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 are the three best known commonly used financial statements include? ›

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.

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 does a $10 increase in depreciation affect the three financial statements? ›

Answer: Income Statement: Operating Income would decrease by $10. If we assume a 40% tax rate, Net Income would decrease by $6. Cash Flow Statement: Net Income is down by $6, but the $10 of Depreciation gets added back because it is a non-cash expense.

Which of the 3 financial statement should be prepared first? ›

Income statement: This is the first financial statement prepared. The income statement is prepared to look at a company's revenues and expenses over a certain period, such as a month, a quarter, or a year.

What are the three steps in analyzing financial statements? ›

Steps To Analyze Financial Statements
  1. Gather And Review Financial Statements. Your first step is to gather your balance sheet, income statement, and cash flow statement for the period. ...
  2. Calculate Financial Ratios. ...
  3. Compare Ratios And Industry Benchmarks. ...
  4. Identify Trends Over Time. ...
  5. Interpret Findings And Draw Conclusions.

How do I comment on financial statements? ›

How to Analyse Financial Statements?
  1. Step 1: Gather the financial statements. ...
  2. Step 2: Review the balance sheet. ...
  3. Step 3: Analyse the income statement. ...
  4. Step 4: Examine the cash flow statement. ...
  5. Step 5: Calculate financial ratios. ...
  6. Step 6: Conduct trend analysis.
Jul 12, 2023

How are balance sheet and cash flow statement related? ›

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 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.

What are the three most important financial statements according to this resource link? ›

The most important financial statements in a company are the P&L statement, Cash Flow Statement, and Balance Sheet.

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