How the 3 Financial Statements are Linked Together

How are the 3 financial statements linked?

The three financial statements are all linked and dependent on each other.  In financial modeling, your first job is to link all three statements together in Excel, so it’s critical to understand how they’re connected.  This is also a common question for investment banking interviews, FP&A interviews, and equity research interviews.

In this tutorial we will break it down for you, although we assume you already have a basic understanding of accounting fundamentals and know how to read financial statements.

Accounting principles

The income statement is not prepared on a cash basis – that means accounting principles such as revenue recognition, matching, and accruals can make the income statement very different from the cash flow of the business.  If a company prepared its income statement entirely on a cash basis (i.e. no accounts receivable, nothing capitalized, etc.) it would have no balance sheet, other than shareholders’ equity and cash.

It’s the creation of the balance sheet through accounting principles that leads to the rise of the cash flow statement, and the three of them are intricately linked.

Net income & Retained Earnings

Net income from the bottom of the income statement links to the balance sheet and cash flow statement.  On the balance sheet, it feeds into retained earnings and on the cash flow statement it is the starting point for the cash from operations section.

PP&E, Depreciation, and Capex

Depreciation and other capitalized expenses on the income statement need to be added back to net income to calculate the cash flow from operations.  Depreciation flows out of the balance sheet from PP&E onto the income statement as an expense, and then gets added back in the cash flow statement.

Capital expenditures add to the PP&E account on the balance sheet and flow through cash from investing on the cash flow statement.Working capital

Changes in current assets and current liabilities on the balance sheet are related to expenses on the income statement, but need to be adjusted on the cash flow statement to reflect the actual amount of cash received or spent by the business.

Financing

Financing events like issuing debt affect all three statements in the following way: the interest expense appears on the income statement, the principle amount of debt owed sits on the balance sheet, and the change in principle amount owed is reflected on the cash from financing section of the cash flow statement.

Cash Balance

Once all of the above items are linked up properly, the sum of cash from operation, cash from investing, and cash from financing are added to the prior period closing cash balance, and the result becomes the current period closing cash balance on the balance sheet.

How to answer the question in an interview

If you get a question along the lines of, “how are the financial statements linked together?” in an interview you shouldn’t go into as much detail as above, but really hit the main points, which are:

  • Net income from the income statement flowing to the balance sheet and cash flow statement
  • Depreciation is added back and capex being deduced on the cash flow statement, which determines PP&E on the balance sheet
  • Financing activities mostly effect the balance sheet and cash from finalizing, except for interest which is shown on the income statement
  • The sum of last period’s closing cash plus this periods cash from operations, investing, and financing is the closing cash balance on the balance sheet

How to link the financial statement for financial modeling

If you’re building a financial model in Excel it’s critical to be able to quickly link the three statements. In order to do this, there are a few basic steps to follow:

  1. Enter at least 3 years of historical financial information
  2. Calculate the drivers / ratios of the business for the historical period
  3. Enter assumptions about what the drivers will be in the future
  4. Build and link the financial statements following the principles discussed above

The model essentially inverts, where the historical period is hardcodes for the statements and calculations for the drivers, then the forecast is hardcodes for the drivers and calculations for the financial statements.

Check out our step by step course to learn how to build a financial model in Excel.

More financial resources

Hopefully this has been a helpful guide on how the financial statements are linked together. To keep learning more please check out these relevant resources: