How the 3 Financial Statements are Linked (2024)

Step-by-step guide

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How are the 3 Financial Statements Linked?

The 3 financial statements are all linked and dependent on each other. In financial modeling, your first job is to link all three statements together in Excel, so it’s critical to understand how they’re connected. This is also a common question for investment banking interviews, FP&A interviews, and equity research interviews. See CFI’s freeinterview guides to learn more.

In this tutorial, we will break it down for you step-by-step, although we assume you already have a basic understanding of accounting fundamentals and know how to read financial statements.

How the 3 Financial Statements are Linked (1)

Want to see a live demonstration? Watch CFI’s free webinar on how to link the 3 financial statements in Excel.

Accounting Principles

The income statement is not prepared on a cash basis – that means accounting principles such as revenue recognition, matching, and accruals can make the income statement very different from the cash flow statement of the business. If a company prepared its income statement entirely on a cash basis (i.e., no accounts receivable, nothing capitalized, etc.) it would have no balance sheet other than shareholders’ equity and cash.

It’s the creation of the balance sheet through accounting principles that leads to the rise of the cash flow statement.

Net Income & Retained Earnings

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 the 3 Financial Statements are Linked (2)

PP&E, Depreciation, and Capex

Depreciation and other capitalized expenses on the income statement need to be added back to net income to calculate the cash flow from operations. Depreciation flows out of the balance sheet from Property Plant and Equipment (PP&E) onto the income statement as an expense, and then gets added back in the cash flow statement.

For this section of linking the 3 financial statements, it’s important to build a separate depreciation schedule.

Capital expenditures add to the PP&E account on the balance sheet and flow through cash from investing on the cash flow statement.

How the 3 Financial Statements are Linked (3)

Working Capital

Modeling net working capital can sometimes be confusing. Changes in current assets and current liabilities on the balance sheet are related to revenues and expenses on the income statement but need to be adjusted on the cash flow statement to reflect the actual amount of cash received or spent by the business. In order to do this, we create a separate section that calculates the changes in net working capital.

How the 3 Financial Statements are Linked (4)

Financing

This can be a tricky part of linking the three statements and requires some additional schedules. Financing events such as issuing debt affect all three statements in the following way: the interest expense appears on the income statement, the principal amount of debt owed sits on the balance sheet, and the change in the principal amount owed is reflected on the cash from financing section of the cash flow statement.

In this section, it’s often necessary to model a debt schedule to build in the necessary detail that’s required.

Cash Balance

This is the final step in linking the 3 financial statements. Once all of the above items are linked up properly, the sum of cash from operations, cash from investing, and cash from financing are added to the prior period closing cash balance, and the result becomes the current period closing cash balance on the balance sheet.

This is the moment of truth when you discover whether or not your balance sheet balances!

How to Answer the Question in an Interview

If you get an interview question along the lines of, “How are the 3 financial statements linked together?” in an interview you shouldn’t go into as much detail as above, but instead simply hit the main points, which are:

  • Net income from the income statement flows to the balance sheet and cash flow statement
  • Depreciation is added back and CapEx is deducted on the cash flow statement, which determines PP&E on the balance sheet
  • Financing activities mostly affect the balance sheet and cash from finalizing, except for interest, which is shown on the income statement
  • The sum of the last period’s closing cash balance plus this periods cash from operations, investing, and financing is the closing cash balance on the balance sheet

If you want to see a video-based example, watch CFI’swebinar on linking the 3 statements.

How to Link the Financial Statements for Financial Modeling

If you’re building a financial model in Excel it’s critical to be able to quickly link the three statements. In order to do this, there are a few basic steps to follow:

  1. Enter at least 3 years of historical financial information for the 3 financial statements.
  2. Calculate the drivers/ratios of the business for the historical period.
  3. Enter assumptions about what the drivers will be in the future.
  4. Build and link the financial statements following the principles discussed above.

The model essentially inverts, where the historical period is hardcoded for the statements and calculations for the drivers, and then the forecast is hardcodes for the drivers and calculations for the financial statements.

Check out CFI’s step-by-step courses to learn how to build financial models in Excel.

Video of Linking the 3 Statements

Watch CFI’s live video demonstration of linking the statements together in Excel.

More Financial Resources

We hope this has been a helpful guide on How the 3 Financial Statements are Linked Together. To keep learning more, please check out these relevant CFI resources:

  • Free Cash Flow
  • EBITDA
  • Debt Schedule
  • Complete Financial Modeling Guide
  • 3 Statement Model
  • DCF Model Guide
  • Types of Financial Models
  • See all accounting resources
How the 3 Financial Statements are Linked (2024)

FAQs

How the 3 Financial Statements are Linked? ›

Net Income & Retained Earnings

What are the three main financial statements explained? ›

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.

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.

Which of the three financial statements are most important? ›

Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.

How do 3 financial statements link together? ›

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 are income statements and balance sheets linked when closing accounts? ›

Answer and Explanation:

When closing accounts during the closing process at the end of an accounting period, the income statement and the balance sheet are linked through the Retained Earnings account in the equity portion of the balance sheet.

How does retained earnings link balance sheet and income statement? ›

Each period, net income from the income statement is added to the retained earnings and is reported on the balance sheet within shareholders' equity. Retained earnings are a key component of shareholder equity and the calculation of a company's book value.

What is the link between the income statement and the statement of owner's equity? ›

The statement of owner's equity is prepared after the income statement. It shows the beginning and ending owner's equity balances and the items affecting owner's equity during the period. These items include investments, the net income or loss from the income statement, and withdrawals.

What is the most important financial statement? ›

The income statement will be the most important if you want to evaluate a business's performance or ascertain your tax liability. The income statement (Profit and loss account) measures and reports how much profit a business has generated over time. It is, therefore, an essential financial statement for many users.

Why is it important to understand financial statements? ›

Key Takeaways. Financial statements provide a snapshot of a corporation's financial health, giving insight into its performance, operations, and cash flow. Financial statements are essential since they provide information about a company's revenue, expenses, profitability, and debt.

What is importance of financial statements? ›

The purpose of financial statements is to allow businesses to understand their financial standing. This provides a summary of previous financial data which can help businesses to make informed decisions. This data can also inform other individuals or companies which may potentially have a state in the business.

What does a balance sheet tell you? ›

The balance sheet provides information on a company's resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company's ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners.

How to calculate net income? ›

It's calculated by subtracting expenses, interest, and taxes from total revenues. Net income can also refer to an individual's pre-tax earnings after subtracting deductions and taxes from gross income.

What is the purpose of a balance sheet? ›

The purpose of a balance sheet is to reveal the financial status of an organization, meaning what it owns and owes. Here are its other purposes: Determine the company's ability to pay obligations. The information in a balance sheet provides an understanding of the short-term financial status of an organization.

What are the main types of financial statements? ›

There are four primary types of financial statements:
  • Balance sheets.
  • Income statements.
  • Cash flow statements.
  • Statements of shareholders' equity.
Nov 1, 2023

What is the balance sheet explained? ›

The balance sheet (also referred to as the statement of financial position) discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners' residual interest in the assets of a company, net of its liabilities.

What is the purpose of the balance sheet? ›

The purpose of a balance sheet is to reveal the financial status of an organization, meaning what it owns and owes. Here are its other purposes: Determine the company's ability to pay obligations. The information in a balance sheet provides an understanding of the short-term financial status of an organization.

Which financial statement must always be prepared first why? ›

The income statement should always be prepared before other statements because it provides an overview of the company's revenue and expenses during a specific period. This information is used in preparing other reports such as balance sheets and cash flow statements.

References

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