All three financial statements are connected although they appear and are represented independently. Investors need to understand how to link the income statement, balance sheet and cash flow statement together. By understanding the transactions and how one change flows through to other statements investors can gain greater insights into a company’s business model. With this knowledge, an investor can value, model, and analyse a company to guide investment decisions.

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It’s important to be able to link financial statements.

We have discussed the Income Statement, Balance Sheet, and Cash Flow Statement, explaining each item and its significance. Now, let’s focus on connecting them all together.

It’s crucial not only to comprehend how the three financial statements are connected but also to understand the impact of changes in various line items on the inflows and outflows. A transaction in one statement can lead to changes in another statement. Investors need to know the business model, how the numbers are determined to be able to make more informed investment decisions.

If you cannot link the statements together, it’s usually one of three reasons I’ve found. There is a gap in your financial literacy, the business model is too complicated, or the accounting methods that are being implemented are a cause for concern.

If you read a company’s financial statements three times, and you still can’t figure out how they make their money, that’s usually for a reason.

Jim Chanos

When analysing or creating financial models to value a business, it’s essential to understand how each business records and conducts its operations. Changes in working capital, inventory, and sales cycles all evolve as a business develops. Understanding how a company arrives at the numbers can provide deeper insights into the business model.

From a financial modelling perspective, linking the statements becomes crucial. Modelling areas such as working capital requires a deep understanding of how the changes translate across all the other statements. Other transactions such as depreciation, capital expenditures, and financing activities impact one another. So, while one activity may seem independent there will be movements (inflows or outflows) across other statements.

The best way to understand this is by explaining the movements in writing and then illustrating how it works. Let’s delve into it.

Why are the financial statements not linked already?

The reason we must make the connections to the statements is due to the accounting principles adopted i.e. GAAP or IFRS. Accounting can be carried out on a cash basis or accrual basis. This means if all companies reported on a cash basis, like say a small business, then there wouldn’t be any need for a balance sheet.

The accrual method creates a vast difference between the Income Statement and the Cash Flow Statement based on the way the company records expenses and income. We need the three statements to determine the income, cost to operate, the overall assets and liabilities as well as the physical cash that moves in and out of the business.

Understanding the Inflows and Outflows.

Below is a simple breakdown of how each statement is connected from an inflow and outflow perspective. Understanding the flow of money and cash in and out across the three statements is often the easiest to comprehend. If you spend in one area, the output will impact another area. For example, spending on more inventories will decrease cash as it is an outflow, and it will increase Accounts Payable because you need to pay suppliers.

Once investors grasp how transactions flow it becomes easier to analyse a business, model it and understand the bigger picture from a value perspective. Understanding the business model is the most important aspect of investing. It’s important to understand how a business makes its money, how a company finances itself, the working capital cycle of the business and all the smaller details that the financial statements reveal.  

Income Statement ➡️ Cash Flow Statement.

The Income Statement is linked to the Cash Flow Statement via Net Income.

The “Bottom Line” of the Income Statement will appear at the very top of the Cash Flow Statement. From here we adjust for non-cash expenses such as depreciation and amortization. We then adjust for changes in working capital to arrive at our Cash Flow from Operations.

⬆️ An increase in Working Capital will be reflected on the Cash Flow Statement as a cash outflow as the company is spending more money on operational expenses.

⬇️ A decrease in Working Capital will be reflected as an inflow on the Cash Flow Statement. This is because less money is being spent on operational needs so more Net Income flows through to the Ending Cash Balance.

Cash Flow Statement ➡️ Balance Sheet.

The Balance Sheet is connected to the cash flow statement due to the cash inflow and outflows from certain transactions. Each activity will either result in cash leaving the balance sheet or cash coming into the balance sheet. The most critical connection to these two statements is the cash balance.

🔚 The ending cash balance on the cash flow statement flows all the way to the TOP of the balance sheet called CASH for the period end.

The changes across these statements are related to three primary activities. The changes in working capital, changes in Capital Expenditures and finally changes in financing activities. As we learned in the Cash Flow Statement blog the three primary activities are Operational, Investing and Financing. What transactions occur from these activities will primarily drive what happens to the balance sheet.

Operational Activity – Working Capital Changes

These changes occur due to the changes in working capital on operational current line items i.e. all the short term activities within a year that impact the businesses cash flow.

⬆️ An increase in current assets causes a Cash Outflow on the balance sheet.

⬇️ A decrease in current assets causes a Cash Inflow on the balance sheet.

⬆️ An increase in current liabilities causes a Cash Inflow on the balance sheet.

⬇️ A decrease in current liabilities causes a Cash outflow on the balance sheet.

Investing Activity – Capital Expenditures

The investing activity from purchasing fixed assets, acquisitions and other capital expenditures will impact the balance sheet. In addition, the sale or disposal of investments or divestments will also change the flow of cash on the balance sheet. Depreciation on the income statement is the bride between the Cash outflows on PP&E, and changes in value on the Balance Sheet.

⬇️ Capital Expenditures (CapEx), purchases of Fixed Assets and Intangible Assets all result in a Cash Outflow on the balance sheet. Obviously the cash comes out of the business to fund these costs.

⬆️ If a company sells an asset, divests from a company then the proceeds from this activity result in a Cash Inflow to the balance sheet.

Financing Activity – Raising Capital

The last link between the cash flow statement and the balance sheet is how the company finances its activities, raises capital or how it rewards shareholders. The company raises money by either issuing more shares or taking on debt. It rewards shareholders by repaying debt, buying back shares, or issuing dividends. There are two primary inflows and three outflows.

⬆️ If a company borrows money to finance its activity it is a Cash Inflow. This is because the debt brings cash into the balance sheet.

⬇️ If a company decided to pay down debt then this results in a Cash Outflow. This is because the company is taking cash from the balance sheet and paying down debt.

⬆️ When a company issues more shares to raise capital this results in a Cash Inflow as cash has come into the balance sheet from the sale of stocks.

⬇️ When a company decides to buy back shares this results in a Cash Outflow. The company is taking the cash out of the balance sheet to fund this activity.

⬇️ The last is when a company decides to issue a dividend this is another Cash Outflow. The company is taking the cash out of the Balance Sheet to give back to shareholders.

Income Statement ➡️ Balance Sheet

The Income Statement is connected to the balance sheet via Net Income. The net income for the period becomes Retained Earnings under shareholders equity on the Balance Sheet. The retained earnings will have dividends deducted if a dividend has been issued.

The retained earnings are accumulated within a business that has not been paid out via dividends. A company either retains its net earnings and cash or pays it out. The Net Income is used for investment activities, capital expenditures and anything to further develop, expand and improve the business.

➖ Negative retained earnings will be caused by a company that has yet to turn a profit and is known as an accumulated deficit. It indicates that a company is spending a lot more to operate than it is bringing in. Whilst it is not always bad, I typically look past companies with significant negative retained earnings. This will also look like negative free cash flow on the cash flow statement but not always reflect no cash on the balance sheet. A company could be well funded from debt or diluting shares but still running at a loss.

Linking Depreciation & Amortization to the Statements.

Depreciation and amortization are both accounting methods used to spread the value of an asset over time (No cash changes hands). Amortization is used for intangible assets like goodwill, patents, and trademarks, and it spreads their value over their useful life. Depreciation, on the other hand, is used for fixed assets like a warehouse, and it expenses the cost of the asset over a certain time frame to account for its decrease in value.

Although depreciation does not directly reduce the value of the fixed asset, the decrease in value is accounted for as an expense.

1️⃣ Purchases of PP&E are recorded on the Balance Sheet with a Depreciation schedule.

2️⃣ Depreciation becomes an expense as a Non-Cash item on the Income Statement.

3️⃣ Depreciation is then Added back to the Cash Flow Statement as operational activity.

4️⃣ Changes in PP&E creates CapEx from Investing Activity on the Cash Flow Statement.

🔗Depreciation, PP&E and Capital Expenditures are all linked.

A depreciation schedule is used to show the decline in value over the asset’s lifetime, and this depreciation is recorded on the Income Statement. As fixed assets and PP&E increase and added to the balance sheet, the depreciation costs also increase on the income statement, and the cash flow related to this is recorded on the cash flow statement under Investing Activities (CapEx).

Depreciation on the Income Statement affect the bottom line, Net Income. When we start with Net Income on the Cash Flow Statement using the indirect method, we need to ADD BACK these non-cash items that count as operational cash flow.

In summary, depreciation flows from the Balance Sheet onto the Income Statement as an expense (a non-cash expense as no cash changes hands), and then it is added back into the Cash Flow Statement.

Linking Working Capital Changes to the Statements.

Changes in Net Working Capital (NWC) flow across all three statements. Linking and understanding working capital is most important when conducting financial modelling. The Cash Flow Statement is always looking to bridge the other two statements together. One of the links is through Operating Working Capital.

Working Capital includes items such as inventory, Accounts Receivables, and Accounts payables and is attributed to the Current Assets and Current Liabilities on the balance sheet. These are all the activities that are short-term within a year. The summary of these activities is known as “Changes in NWC”.

The changes in current assets and current liabilities from the Balance Sheet are the basic calculation for operating working capital in the Operating Activity segment on the Cash Flow Statement.

Here are the key areas to understand.

• When inventory increases on the Balance Sheet it creates a Cash Outflow in cash flow.
• If Accounts Receivables decline on the Balance Sheet this creates a cash inflow.
• When a sale is made it is recorded as either cash or accounts receivables.
• Accounts receivables increase when a company sells something but does not collect cash.
• Prepaid costs (costs paid in advance) in operational expenses impact working capital.
• Accounts Payable (when purchases are made with credit) impacts working capital.
• If a business receives inventory (assets) without paying Accounts Payable rises.
• More debt creates an Interest Expense as the debt needs to be serviced.
• When paying debt down it will reduce the cash and equivalents section on the balance sheet.

🔑 These are a few of the key links between Working Capital and the three financial statements.

Financing Activity and the 🔗 between Statements.

The impact of financing activity can be a bit confusing when trying to connect it across the three financial statements. Financing affects all three statements. When a company decides to take on debt, here is how the loan impacts the business:

1️⃣ The debt will result in a cash inflow from financing activity on the Cash Flow Statement. A loan brings a cash inflow into the business to fund operations.

2️⃣ The debt will then be recorded on the Balance Sheet under Long-Term Debt if it is a long-term loan, or under Current Liabilities as a short-term loan. So, the principal amount sits under the liabilities on the Balance Sheet.

3️⃣ The debt incurs interest, which becomes a business expense and appears on the Income Statement below EBIT (Earnings Before Interest and Tax).

So, while debt sits on the balance sheet as a liability and creates a cash inflow on the Cash Flow Statement, it becomes an expense (business deduction) on the Income Statement as interest is an operational expense to service debt.

📉 If a company decides to pay DOWN this debt, it will take cash from the Balance Sheet under Current Assets and use it to pay the debt off. This then creates a cash outflow on the Cash Flow Statement under financing activity, as it will reduce the ending cash balance.

A list of other areas that are interlinked.

I’ve outlaid below a list of all the other areas that connect financial statements that are important when understanding the movements between transactions.

Financial Statement	🔗The Link
Balance Sheet ➡️ Income Statement	When a sale is made, this reduces the inventory value as it moves to the Cost of Goods Sold on the Income Statement.
Balance Sheet ➡️ Cash Flow Statement	If a customer pays for the product the amount moves from Accounts Receivables to Cash Receipts as the money changed hands.
Cash Flow Statement ➡️ Balance Sheet	An increase in the Cash Receipt creates an Increase in the Cash on the Balance Sheet.
Income Statement ➡️ Balance Sheet	When an expense is incurred on the Income Statement it also creates a rise in Accounts Payable on the Balance Sheet.
Balance Sheet ➡️ Cash Flow Statement	Once a supplier is paid the Accounts Payable declines and moves to the Operational Activity on the Cash Flow Statement.
Cash Flow Statement ➡️ Balance Sheet	When Investing Activity increases (Net Borrowings) this increases the Cash and Debt portion on the Balance Sheet.
Income Statement ➡️ Balance Sheet	If depreciation is entered as an expense on the Income Statement it increases accumulated depreciation on the Balance Sheet.

These are some simple transactions and how they flow through each of the statements.

In Summary…

I’ve gone through several areas showing how certain transactions are linked throughout the statements. It is not difficult to understand once you look at it from an inflow and outflow perspective.

The best way to think about the link between statements is to consider how one transaction may impact another line item. Once you grasp the basics of cash flows, how inventory works, accounts payable, accounts receivables, depreciation, financing activity, and investing activity, you will be able to understand the business model in detail.

Why is this important? When we value a business, look at the risks involved, or try to model the statements to determine future multiples, we need to understand all the transactions that go into a business.

As a simple example, you can have two businesses in the same industry, selling a similar product or service. One company may have different payment terms for both customers and suppliers. Let’s assume the first company gets paid upfront and has extended payment terms with its suppliers. Let’s also assume this business uses no debt and funds growth from cash flow due to the favourable payment structure.

The second business extends its offering to customers but does not collect cash straight away and builds up accounts receivables. Let’s also assume the business is required to pay for inventory upfront to suppliers. This change in a simple structure will cause massive changes in working capital cycles. The second company may need to finance operations a lot more than the first business.

Once you start linking it all together, you start to see the business structure a lot clearer. Such as the sales cycle, working capital cycle and financing demands. This can shine a light on whether the business is an opportunity or not.