How are the Three Financial Statements Linked?

How are the Financial Statements Linked?

One common interview question that you’re likely to encounter in an investment banking interview is, “How Are the Three Financial Statements Linked Together?”

To successfully answer this question, make sure you have the financial accounting fundamentals down pat.

Poor answers are ones that are too wordy or miss key linkages.

Retained Earnings: Concept Review

Before we provide an example response to the common interview question, we’ll review the concept of retained earnings.

In short, retained earnings represents the cumulative profits kept by a company since inception, as opposed to paying shareholders in the form of dividends.

The formula for calculating retained earnings consists of determining the beginning of period retained earnings balance, adding the current period net income, and subtracting the dividends issued to shareholders.

Example Great Answer to Interview Question

“The bottom line of the income statement is net income.  Net income links to both the balance sheet and cash flow statement.

In terms of the balance sheet, net income flows into stockholder’s equity via retained earnings.  Retained earnings is equal to the previous period’s retained earnings plus net income from this period less dividends from this period.

In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations.  Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations.

Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash.  The net change in cash on the cash flow statement and cash from the previous period’s balance sheet comprise cash for this period.”

For a deeper dive, watch this video.