The short answer
How are the three financial statements linked?
Net income flows from the company's income statement to the balance sheet as retained earnings. The cash flow statement opens with net income
The cash flow statement adjusts net income with operating, investing and financing cash flows. The "net changes in cash flow" flow into the balance sheet and are added to the cash balance
Changes in working capital, such as accounts receivable, accounts payable and inventory, are reflected in the cash flow statement and flow into the balance sheet
Property, plant and equipment (PP&E) on the balance sheet are purchased with capital expenditures, which run through the cash flow statement. Depreciation expense runs through the income statement and is added back to the cash flow statement because it is a non-cash expense
Financing activities, such as raising debt, run through the company's cash flow statement and affect the cash and debt balance on the balance sheet. Interest expense appears on the income statement and impacts net income
That's how the three financial statements are linked.
Understanding the links between them is crucial for financial modeling and Investment Banking interviews.
Why are the three financial statements linked together?
Three Financial Statements are linked together.
The income statement is prepared on an accrual basis and recognizes revenue and expenses when generated. The income statement reflects a company's profitability within the fiscal year.
It is not prepared on a cash basis and does not represent cash flow. Net income does not equal cash flow.
So, we need a cash flow statement. The cash flow statement shows how much cash the company has based on actual cash transactions. It shows how the company arrived at its ending cash balance.
Next, we need a balance sheet representing a company's financial condition on a specific day. It shows the company's assets, as well as shareholders' equity and liabilities.
Here, we can find, amongst others, property plant and equipment, accounts receivables or the previous period's retained earnings. All these items are specific to the balance sheet and would be left out if we didn't have one.
To assess a company's financial performance within an accounting period, you would look at the income statement and the cash flow statement.
To assess what the company owns and owes, you would look at the balance sheet. That's how you read financial statements.
Net income and retained earnings
First, the income statement links to the balance sheet. Net income links from the bottom of the income statement flows to the balance sheet as retained earnings.
Net income can be paid out as dividends to shareholders but can also be critical to the company as retained earnings.
Next, net income opens the cash flow statement.
The income statement and its profitability metrics, such as gross profit, operating income or net income, do not equal cash flow.
So, we need to adjust for operating cash flow, investing cash flow and financing cash flow. Once all these adjustments are made, we are left with the net changes in cash for the period.
Cash flow statement and ending cash balance
Once all the cash adjustments are made, the net cash flow is added to the prior period closing cash balance.
The result is the current period closing cash balance on the balance sheet. This is the moment of truth in financial modeling. This is when you discover whether your balance sheet balances.
PP&E, capex and depreciation
Property, plant and equipment (PP&E) is an asset in the balance sheet.
PP&E is purchased with capital expenditures, which runs through the cash flow statement in the cash flow from investing section. In turn, capital expenditures do not flow through the income statement.
As PP&E is used up during its useful lifespan, it depreciates. This depreciation expense runs through the income statement and is added back to the cash flow statement because it is a non-cash expense. The cash expense of depreciation is capital expenditures.
Changes in net working capital
Changes in net working capital affect the balance sheet and the cash flow statement.
If revenue is made, you send out an invoice. However, the invoice was not paid immediately. It is recorded as accounts receivable. If the customer pays the invoice, the respective accounts receivable goes down on the balance sheet and a cash inflow is recorded on the cash flow statement.
The same thing happens to most operating expenses. You get an invoice. That invoice is unpaid. It is recorded as accrued expenses. On the balance sheet, it shows up as accounts payable. Then, you pay the invoice. Accounts payables go down on the balance sheet and a cash outflow is recorded on the cash flow statement.
If inventory goes up on the balance sheet, cash goes down on the cash flow statement. No changes to the income statement.
The sum of these changes in net working capital is found on the cash flow statement.
Financing activities and interest expense
Financing activities, such as issuing debt, affect all three statements.
The principal amount owed is paid out. This is reflected in the cash flow statement's cash from financing section. Next, the principal amount of debt owed sits on the balance sheet.
Interest expense appears on the income statement and impacts net income.
Debt repayments on the cash flow statement and balance sheet.
How to answer "How are the three financial statements linked" in an interview
How are the three Financial Statements linked? This is a common question for investment banking interviews. You must know if you want to win an internship or full-time role. Here is a good answer for an interview situation:
Net income from the income statement flows to the balance sheet and cash flow statement
The cash flow statement adjusts net income with operating, investing and financing cash flows. The net changes in cash flow run into the balance sheet and are added to the cash balance
PP&E on the balance sheet is built up with capital expenditures, which run through the cash flow statement. Depreciation runs through the income statement and is added back to the cash flow statement
Financing activities, such as raising debt, run through the cash flow statement and affect the cash and debt balance on the balance sheet. Interest expense appears on the income statement and impacts net income
How to link the three financial statements for financial modeling?
Knowing how the three financial statements are linked is critical for financial modeling.
Here is how you would build it:
First, you model the income statement, including the projection period
Then, you calculate PP&E, capex and depreciation in your depreciation schedule
Then, prepare your debt schedule
Then, you project your balance sheet
Finally, you model your cash flow statement based on the changes on your balance sheet
The links are all the same as laid out in this article:
Net income flows into the balance sheet as retained earnings. It is also the opening line of the cash flow statement
The cash flow statement adjusts net income with (1) changes in net working capital, (2) PP&E, capex and depreciation, as well as (3) financing activities and interest expense
The resulting net changes in cash are netted with the prior period closing cash balance, which flows back into the balance sheet
The balance sheet balances
That's how a three-statement model links.
