How Are The Three
Financial Statements Linked?
The Ultimate Guide on how the Three Financial Statements link together, including illustrative Examples
Table of Contents
1. The Importance of Understanding how the Three Financial Statements link together
While it is essential to understand the income statement, balance sheet and cash flow statement on a stand-alone basis, it is equally important to know how the three financial statements link together.
Especially in investment banking, corporate M&A and private equity, analysts spend a great deal of time on financial modeling. Financial models are simplified representations and forecasts of the performance of businesses or assets. They can help to understand, among other things, how a business is estimated to evolve in the future, what a fair price for the enterprise or asset would be, and what capital needs the company might face.
That said, a financial model needs to have appropriately linked financial statements as well as a balancing balance sheet. What’s more, analysts must understand the concept of circularity in a financial model.
The section below will give you an easy-to-understand overview of how the three financial statements are linked, followed by a few practice examples you can use for making sure that you understood the basic concepts.
Also, make sure you have read our guides on the three financial statements, before tackling the section below.
2. Net Income and Retained Earnings
Net income is the bottom line of the income statement. It is the amount after subtracting all costs that a business incurs from the generated revenue.
At the same time, net income is also the first item in the operating cash flow on the cash flow statement. The operating cash flow measures how much of the net income was collected in cash.
Furthermore, the remaining part of net income that was not paid out to shareholders in the form of dividends will flow into retained earnings on the balance sheet. As retained earnings is a balance, it represents the sum of all past net incomes or losses of the business, less dividends paid out to shareholders.
In our example, the business generated €12m in net income in 2019. The €12m are the basis for the cash flow statement, which shows that only €8m of the net income were collected in cash. As none of the €12m were paid out to shareholders, the retained earnings position on the balance sheet increase by the full amount of €12m from €7m in 2018 to €19m in 2019.
3. Depreciation, Amortization (“D&A”) and Property, Plant and Equipment (“P&E”)
D&A are write-offs of tangible (depreciation) and intangible (amortization) assets. They follow the principle that assets lose value over time. Therefore, PP&E reduces by the amount of depreciation on the balance sheet, while intangible assets (goodwill, patents, trademarks) would decrease by the amount of amortization.
Although PP&E and intangibles decrease through D&A, they can increase in the same period due to investment in, amongst others, new machines, property and patents. As a result, the current period’s PP&E is the result of the previous period’s PP&E plus investments, less depreciation of the current period.
D&A are accounting costs that go through the income statement and effectively reduce net income. However, as D&A never impacts cash, it must be added back to the net income in the operating cash flow on the cash flow statement.
For simplification purposes, we assumed that in the example, the €2m D&A only consist of depreciation, so write-offs of tangible assets. This means that PP&E depreciated by €2m from €20m in 2018 to €18m in 2019. However, as the company invested in a new machine in the amount of €1m, PP&E effectively only decreased to €19m.
As the €2m in depreciation are accounting costs only, they are added back to the net income on the cash flow statement. At the same time, the €1m investment in the machine will be deducted from the cash flow, as it represents a cash outflow.
Yet, the €2m must be recognized on the income statement, as the income statement recognizes cost irrespectively of its impact on cash.
4. Operating Working Capital
Operating working capital is defined as the non-cash current assets less non-interest-bearing current liabilities.
An increase in non-cash current assets, i.e. accounts receivables and inventory, represents a tie-up of cash. This happens because a customer has not yet paid or because the company bought materials and goods for the purpose of manufacturing products. Vice versa, a decrease in these assets means that the company used up the materials or received the cash payment of the customers, so effectively released cash.
If we look at current liabilities, an increase in accounts payable means that the company was supplied with goods but has not yet paid the invoice hence represents a non-cash activity. Vice versa, a decrease in accounts payable indicates that the company paid invoices and, therefore, consumed cash.
In our example, accounts receivables and inventory both increased from €15m in 2018 to €19m in 2019. That means that the company bought goods and materials for cash and, at the same time, sold products on credit in the total amount of €8m. As these activities tied-up cash, they have to be reduced from net income in the operating cash flow section of the cash flow statement.
In parallel, the company received invoices in the amount of €2m (an increase from €10m in 2018 to €12m in 2019) that are still to be paid. These accounts payable must be added back to net income on the cash flow statement until they are paid.
5. Debt Repayment
If a company issues debt, e.g. in the form of loans, it usually has to repay that debt via regular principal payments plus interest. For simplification purposes, we assume there is no interest charged. Otherwise, it would get quite complex (see circular reference).
When a company takes on a loan, the investing cash flow will increase by the amount of debt raised. Vice versa, if it repays the loan, the investing cash flow is reduced by the principal until the loan is repaid.
In parallel, the balance position “long-term debt” increases or decreases by the amount raised or repaid.