Learn the intricate workings of linking the three financial statements: the income statement, balance sheet, and cash flow statement. This article helps you grasp the relationship between important financial concepts like Net Income, Retained Earnings, Depreciation, Capex, Working Capital, and Financing, all of which impact the three financial statements.
Key Insights
- The 3 financial statements are interdependent, making it critical to know how to link them together in Excel for financial modeling.
- Net income serves as a link between the income statement, balance sheet, and cash flow statement, feeding into retained earnings and being the starting point for the cash from operations section.
- Depreciation and other capitalized expenses on the income statement affect the balance sheet and the cash flow statement, necessitating a separate depreciation schedule for accurate financial modeling.
- Capital expenditures impact the Property Plant and Equipment (PP&E) account on the balance sheet and the cash from investing on the cash flow statement.
- Modeling net working capital can be complex due to its impact on current assets and liabilities on the balance sheet, revenues and expenses on the income statement, and adjustments on the cash flow statement.
- Financing events, such as issuing debt, affect all three financial statements and often require modeling a debt schedule for detailed insights.
Statement Linkages
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Income Statement
Net income flows to retained earnings on the balance sheet.
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Cash Flow Statement
Starts with net income; reconciles to ending cash on balance sheet.
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Balance Sheet
Snapshot at a point in time — connects to other two via retained earnings and cash.
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Working Capital Changes
Balance sheet AR/AP/inventory changes show up in CFO via working capital section.
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.
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.
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.
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.
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 your balance sheet balances!
