The Three Major Financial Statements: How They're Interconnected (2024)

The information found on the financial statements of an organization is the foundation ofcorporate accounting. This data is reviewed by management, investors, and lenders for the purpose of assessing the company's financial position.

Data found in the balance sheet, the income statement, and the cash flow statement is used to calculate important financial ratios that provide insight on the company’s financial performance and potential issues that may need to be addressed. The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. Together the three statements give a comprehensive portrayal of the company’s operating activities.

Key Takeaways

  • The information found on the financial statements of an organization is the foundation ofcorporate accounting.
  • Also referred to as the statement of financial position, a company'sbalance sheet provides information on what the company is worth from a book value perspective.
  • A company'sincome statementprovides details on the revenue a company earns and the expenses involved in its operating activities.
  • Thecash flow statementprovides a view of a company’s overall liquidity by showing cash transaction activities.

The Balance Sheet

Also referred to as the statement of financial position, a company'sbalance sheet provides information on what the company is worth from a book value perspective. The balance sheet is broken into three categories and provides summations of the company's assets, liabilities, and shareholders' equity on a specific date.

Generally, a comprehensive analysis of the balance sheet can offer several quick views. In order for the balance sheet to ‘balance,’ assets must equal liabilities plus equity. Analysts view the assets minus liabilities as the book value or equity of the firm. In some instances, analysts may also look at the total capital of the firm which analyzes liabilities and equity together. In the asset portion of the balance sheet, analysts will typically be looking at long-term assets and how efficiently a company manages its receivables in the short term.

There are a variety of ratios analysts use to gauge the efficiency of a company’s balance sheet. Some of the most common include asset turnover, the quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.

The Income Statement

A company'sincome statementprovides details on the revenue a company earns and the expenses involved in its operating activities. Overall, it provides more granular detail on the holistic operating activities of a company. Broadly, the income statement shows the direct, indirect, and capital expenses a company incurs.

Starting with direct, the top line reports the level of revenue a company earned over a specific time frame. It then shows the expenses directly related to earning that revenue. Direct expenses are generally grouped into cost of goods sold or cost of sales, which represents direct wholesale costs. Costs of sales are subtracted from revenue to arrive at gross profit. Gross profit is then often analyzed in comparison to total sales to identify a company’s gross profit margin.

Indirect expenses are also an important part of the income statement. Indirect expenses form a second category and show all costs indirectly associated with the revenue-generating activities of a firm. These costs can include salaries, general and administrative expenses, research and development, and depreciation and amortization. Together these indirect expenses are subtracted from gross profit to identify operating income.

The final category on the income statement factors in capital expenses. The last expenses to be considered here include interest, tax, and extraordinary items. The subtraction of these items results in the bottom line net income or the total amount of earnings a company has achieved.

Offering a great deal of transparency on the company’s operating activities, the income statement is also a key driver of the company’s other two financial statements. Net income at the end of a period becomes part of the company’s stockholders' equity as retained earnings.Net income is also carried over to the cash flow statement where it serves as the top line item for operating activities. Sales booked during the period are also added to the company’s short-term assets as accounts receivable.

On the income statement, analysts will typically be looking at a company’s profitability. Therefore, key ratios used for analyzing the income statement include gross margin, operating margin, and net margin as well as tax ratio efficiency and interest coverage.

The Cash Flow Statement

Thecash flow statementprovides a view of a company’s overall liquidity by showing cash transaction activities. It reports all cash inflows and outflows over the course of an accounting period with a summation of the total cash available.

Standard cash flow statements will be broken into three parts: operating, investing, and financing. This financial statement highlights the net increase and decrease in total cash in each of these three areas.

The operating portion shows cash received from making sales as part of the company's operations during that period. It also shows the operating cash outflows that were spent to make those sales. For example, the cash paid for rent, salaries, and administration.

The other two portions of the cash flow statement, investing and financing, are closely tied with the capital planning for the firm which is interconnected with the liabilities and equity on the balance sheet. Investing cash activities primarily focus on assets and show asset purchases and gains from invested assets. The financing cash activities focus on capital structure financing, showing proceeds from debt and stock issuance as well as cash payments for obligations such as interest and dividends.

A Comprehensive View

All three accounting statements are important for understanding and analyzing a company’s performance from multiple angles. The income statement provides deep insight into the core operating activities that generate earnings for the firm. The balance sheet and cash flow statement, however, focus more on the capital management of the firm in terms of both assets and structure.

Overall, top-performing companies will achieve high marks in operating efficiency, asset management, and capital structuring. Management is responsible for overseeing these three levers in a way that serves the best interest of the shareholders, and the interconnected reporting of these levers is what makes financial statement reporting so important.

The Three Major Financial Statements: How They're Interconnected (2024)

FAQs

The Three Major Financial Statements: How They're Interconnected? ›

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 ...

What are the 3 financial statements and how are they connected? ›

The income statement, balance sheet, and cash flow all connect to create the three-statement model. How? Changes in current assets and liabilities on the balance sheet are reflected in the revenues and expenses that you see on the income statement.

How financial statements are interlinked to each other? ›

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.

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 is the link between balance sheet and cash flow statement? ›

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 3 main financial statements and their purpose? ›

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 3 main types of financial statements and how do they differ? ›

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 interrelationship among the four financial statements? ›

Finally, it is important to note that the income statement, statement of retained earnings, and balance sheet articulate. This means they “mesh together” in a self-balancing fashion. The income for the period ties into the statement of retained earnings, and the ending retained earnings ties into the balance sheet.

What is the relationship between the 4 financial statements? ›

All four accounting financial statements accurately portray the company's overall financial situation. The income statement records all revenues and expenses. The balance sheet provides information about assets and liabilities. The cash flow statement shows how cash moves in and out of the business.

What is the major connection between the statements of financial position and performance? ›

Answer and Explanation:

The statement of financial performance uses information from the statement of financial position for its reporting. The Financial performance uses the assets, liabilities, and equity from the statement of position in its activity.

What are the 3 types of financial statements? ›

The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. Together the three statements give a comprehensive portrayal of the company's operating activities.

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 connection between the income statement and the balance sheet quizlet? ›

The main link between the two statements is that profits generated in the income statement get added to shareholder's equity on the balance sheet as retained earnings. Also, debt on the balance sheet is used to calculate interest expense in the income statement.

How are the cash flow statement and income statement connected? ›

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.

Which is better cash flow or balance sheet? ›

There is no need to compare whether a cash flow statement or balance sheet is more important. They both reveal unique insights and information about a business's finances and can be used to create informed future decisions and forecasts.

Which is more important balance sheet or income statement? ›

However, many small business owners say the income statement is the most important as it shows the company's ability to be profitable – or how the business is performing overall. You use your balance sheet to find out your company's net worth, which can help you make key strategic decisions.

What are the 3 financial statements that are forecasted? ›

The 3-Statement Model is an integrated model used to forecast the income statement, balance sheet, and cash flow statement of a company for purposes of projecting its forward-looking financial performance.

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.

What are the 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

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.

References

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