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.
Table of Contents
- Income Statement → Cash Flow Statement Linkages
- Cash Flow Statement → Balance Sheet Linkages
- Income Statement → Balance Sheet Linkages
- Financial Statement Linkages Excel Template
- Financial Statement Linkages Example
- Net Income and Depreciation & Amortization
- Change in Net Working Capital (NWC)
- CapEx and PP&E
- Debt Issuances and Interest Expense
- Cash Balance and Retained Earnings
Income Statement → Cash Flow Statement Linkages
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.
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.
Financial Statement Linkages Excel Template
Now that we’ve defined the main linkages between the three financial statements, we can complete an example modeling exercise in Excel. Fill out the form below to access the file:
Financial Statement Linkages Example
In our simple model, we have the three financial statements side-by-side of a hypothetical company.
Net Income and Depreciation & Amortization
To briefly go through our illustrative example, we can first track how net income is the beginning line item on the cash flow statement in the Cash from Operations section (e.g. the $15m in Year 0 net income is the top line item on the CFS in the same period).
Below net income, we can see how depreciation & amortization is added back on the cash flow statement due to being a non-cash add back. The real cash outlay, CapEx, already occurred and appears in the cash from investing section.
While D&A is typically embedded within COGS/OpEx on the income statement, we’ve broken it out on the income statement for purposes of simplicity – for example, the $10m in D&A expensed on the income statement in Year 0 is added back on the CFS.
Change in Net Working Capital (NWC)
The change in net working capital captures the difference between the prior NWC and current NWC balance – and an increase in NWC represents a cash outflow (and vice versa).
From Year 0 to Year 1, A/R increases by $10m while A/P increases by $5m, so the net impact is an increase in NWC of $5m.
Here, the increase of A/R means that the number of customers that paid on credit has increased – which is a cash outflow as the company has yet to receive the cash from the customer despite “earning” the revenue under accrual accounting.
CapEx and PP&E
Going further down the cash flow statement, the CapEx line item appears in the Cash from Investing section.
CapEx does NOT impact the income statement directly, but rather, depreciation spreads the cost of the outflow to match the timing of the benefits with the costs (i.e. the matching principle).
As for the balance sheet, the PP&E balance increases by the CapEx amount – for example, the PP&E balance of $100m in Year 0 increases by the $20m in CapEx.
However, the $10m in depreciation expense reduces the PP&E balance, so the net PP&E balance in Year 0 is equal to $110m.
Debt Issuances and Interest Expense
For the Cash from Financing section, we have one inflow of cash, which is the raising of capital through debt issuances, which represent cash inflows since debt is raised in exchange for cash from lenders.
In Year 0 and Year 1, our company raised $50m and then $60m, respectively.
The calculation of interest expense is based on the beginning and ending debt balance, which is multiplied by our simple 6.0% interest rate assumption.
For example, the interest expense in Year 1 is equal to approximately $5m.
Cash Balance and Retained Earnings
In Year 0, the beginning cash is assumed to be $60m and upon adding the net change in cash (i.e. the sum of the cash from operations, cash from investing, and cash from financing sections), we get $50m as the net change and $110m as the ending cash balance.
The $110m in ending cash on the CFS in Year 0 flows to the cash balance shown on the balance sheet, in addition to rolling-over to be the beginning cash balance for the next year.
As explained earlier, the retained earnings account is equal to the prior period balance, plus net income, and minus any dividends issued.
Thus, for Year 1, we add the net income of $21m to the prior balance of $15m to get $36m as the ending retained earnings balance.