Three Financial Statements

What are the Three Financial Statements?

The three financial statements are (1) the income statement, (2) the balance sheet, and (3) the cash flow statement. Each of the financial statements provides important financial information for both internal and external stakeholders of a company.

The income statement illustrates the profitability of a company under accrual accounting rules. The balance sheet shows a company’s assets, liabilities, and shareholders’ equity at a particular point in time. The cash flow statement shows cash movements from operating, investing, and financing activities.

These three core statements are intricately linked to each other and this guide will explain how they all fit together. By following the steps below, you’ll be able to connect the three statements on your own.

Overview of the Three Financial Statements

1. Income Statement

Often, the first place an investor or analyst will look is the income statement. The income statement shows the performance of the business throughout each period, displaying sales revenue at the very top. The statement then deducts the cost of goods sold (COGS) to find gross profit.

From there, gross profit is impacted by other operating expenses and income, depending on the nature of the business, to reach net income at the bottom — “the bottom line” for the business.

Key Features

• Shows the revenues and expenses of a business
• Expressed over a period of time (i.e., 1 year, 1 quarter, year-to-date, etc.)
• Uses accounting principles such as matching and accruals to represent figures (not presented on a cash basis)
• Used to assess profitability

2. Balance Sheet

The balance sheet displays the company’s assets, liabilities, and shareholders’ equity at a point in time. The two sides of the balance sheet must balance: assets must equal liabilities plus equity. The asset section begins with cash and equivalents, which should equal the balance found at the end of the cash flow statement.

The balance sheet then displays the ending balance in each major account from period to period. Net income from the income statement flows into the balance sheet as a change in retained earnings (adjusted for payment of dividends).

Key Features

• Shows the financial position of a business
• Expressed as a “snapshot” or financial picture of the company at a specified point in time (i.e., as of December 31, 2017)
• Has three sections: assets, liabilities, and shareholders’ equity
• Assets = Liabilities + Shareholders Equity

3. Cash Flow Statement

The cash flow statement then takes net income and adjusts it for any non-cash expenses. Then cash inflows and outflows are calculated using changes in the balance sheet. The cash flow statement displays the change in cash per period, as well as the beginning and ending balance of cash.

Key Features

• Shows the increases and decreases in cash
• Expressed over a period of time (i.e., 1 year, 1 quarter, year-to-date, etc.)
• Undoes accrual accounting principles to show pure cash movements
• Has three sections: cash from operations, cash used in investing and cash from financing
• Shows the net change in the cash balance from the start to the end of the period

Summary Comparison of the Three Financial Statements

How are These 3 Core Statements Used in Financial Modeling?

Each of the three financial statements has an interplay of information. Financial models use the trends in the relationship of information within these statements, as well as the trend between periods in historical data to forecast future performance.

The preparation and presentation of this information can become quite complicated. In general, however, the following steps are followed to create a financial model.

• Line items for each of the core statements are created. It provides the overall format and skeleton that the financial model will follow
• Historical numbers are placed in each of the line items
• At this point, the creator of the model will often check to make sure that each of the core statements reconciles with the data in the other. For example, the ending balance of cash calculated in the cash flow statement must equal the cash account in the balance sheet
• An assumptions section is prepared within the sheet to analyze the trend in each line item of the core statements between periods
• Assumptions from existing historical data are then used to create forecasted assumptions for the same line items
• The forecasted section of each core statement will use the forecasted assumptions to populate values for each line item. Since the analyst or user has analyzed past trends in creating the forecasted assumptions, the populated values should follow historical trends
• Supporting schedules are used to calculate more complex line items. For example, the debt schedule is used to calculate interest expense and the balance of debt items. The depreciation and amortization schedule is used to calculate depreciation expense and the balance of long-term fixed assets. These values will flow into the three main statements.

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Additional Resources

Free Reading Financial Statements Course

Free Financial Modeling Guide

How to Link the 3 Statements

Variable Overhead Spending Variance

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