How are the Financial Statements Linked?
Under accrual accounting, the three financial statements consist of the income statement, balance sheet, and cash flow statement, each closely interlinked with one another.
Income Statement → Cash Flow Statement Linkages
To start, the cash flow statement is connected to the income statement through net income.
The net income metric, or the “bottom line” of the income statement, becomes the starting line item at the top of the cash flow statement in the cash from operations section.
From there, net income is adjusted for non-cash expenses like depreciation & amortization and the change in net working capital (NWC) to calculate how much of net income was collected in real cash.
Cash Flow Statement → Balance Sheet Linkages
Conceptually, the cash flow statement is linked to the balance sheet since one of its purposes is to track the changes in the balance sheet’s working capital accounts (i.e. current assets and liabilities).
- Increase in NWC: An increase in net working capital (e.g. accounts receivables, inventory) represents an outflow of cash as more cash is tied up in operations.
- Decrease in NWC: In contrast, a decrease in NWC is an inflow of cash – for example, if A/R decreases, that means the company collected cash payments from customers.
The impact from capital expenditures – i.e. the purchase of PP&E – is also reflected on the cash flow statement. CapEx increases the PP&E account on the balance sheet but does NOT appear on the income statement directly.
Instead, the depreciation expense – i.e. the allocation of the CapEx amount across the useful life assumption – reduces PP&E.
In addition, the issuance of debt or equity to raise capital increases the corresponding amount on the balance sheet, while the cash impact is reflected on the cash flow statement.
Finally, the ending cash balance at the bottom of the cash flow statement flows to the balance sheet as the cash balance for the current period.
Income Statement → Balance Sheet Linkages
The income statement is connected to the balance sheet via retained earnings.
Of the portion of net income kept by the company, as opposed to being paid out as dividends to shareholders, the remainder flows into retained earnings on the balance sheet, which represents the cumulative sum of all net earnings (or losses) of the company minus dividends issued to shareholders.
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 during the current period.
Interest expense, the cost associated with debt financing, is expensed on the income statement and calculated off the beginning and ending debt balances on the balance sheet.
Lastly, PP&E on the balance sheet is reduced by depreciation, which is an expense embedded within cost of goods sold (COGS) and operating expenses (OpEx) on the income statement.
