How Are the Three Financial Statements Linked?

Last Updated May 22, 2024

Say you’re a business owner looking to expand. You’re preparing for a loan application or seeking investment from outside sources. In this scenario, you must demonstrate your company’s financial health and stability to lenders or investors. Understanding the link between the three major financial statements—the balance sheet, cash flow statement, and profit and loss statement—means you can present a comprehensive view of your company’s financial position.

But the importance of the link between these documents goes beyond raising capital. Knowing how the three financial statements are linked means you can analyze your current operations and plan strategically for the future.

What Are the Three Major Financial Statements?

The foundation of financial reporting is in three important documents: the balance sheet, the cash flow statement, and the profit and loss (P&L) statement. Each serves a unique purpose, the sum of which is a 360-degree view of a company’s financial health.

Balance Sheet

The business balance sheet is a snapshot at a point in time that shows what a company owns (assets), what it owes (liabilities), and the shareholders’ equity. It’s a statement of financial position that outlines the company’s net worth. It offers useful insights into a business’s stability and capacity to handle more debt—or expand business operations.

Cash Flow Statement

The cash flow statement tracks the actual cash coming in and going out of the business over a period. It breaks down cash flow and operations, investing, and financing activities. It’s particularly helpful for understanding the company’s ability to generate cash to fund its operations, pay debts, and return money to shareholders.

Profit and Loss Statement

Also known as the income statement, the profit and loss statement summarizes the company’s revenues, costs, and expenses incurred during a specific period. It shows how the business performs operationally, indicating whether it can generate profit by increasing revenue, reducing costs, or both.

What Does Each Financial Statement Show?

Below is a basic definition of what information each financial statement reveals about a business.

Balance Sheet

The balance sheet shows a detailed snapshot of a company’s financial condition at a specific moment. It’s structured around the fundamental equation:

Assets = Liabilities + Shareholders’ Equity

Assets, or what the company owns, are balanced by the company’s obligations (liabilities) and the equity invested by its owners (shareholders’ equity). This statement shows the company’s ability to pay off its debts in the short-term (liquidity) and its financial stability in the long-term (solvency).

Cash Flow Statement

The cash flow statement shows how changes in the balance sheet and income affect cash and cash equivalents. It breaks down the cash generated or used in three areas:

• Operating Activities: Daily business operations
• Investing Activities: Purchase or sale of assets, investments
• Financing Activities: Debts, dividends, and equity

The cash flow statement helps a company understand its liquidity and shows how well it generates cash to meet its debt obligations, operations, and investments. Therefore, business owners can alter processes moving forward in an effort to improve cash flow.

Profit and Loss Statement

The profit and loss statement, or income statement, shows a tracking of revenue, expenses, and profits over a period of time. When making a profit and loss statement, start with the total revenue, subtract the costs of doing business, and end with the net income.

Business owners and investors will read and analyze a profit and loss statement to determine how well the company uses its resources to generate profit and manage expenses. It is a key document for assessing and evaluating a company’s performance over time.

How to Link the Three Financial Statements for Financial Modeling

Financial modeling requires a deep understanding of the interconnection between the three major financial statements. This section outlines the essential links that bring them together. It is a general blueprint for constructing a financial model for your business.

Link Net Income (on the Profit and Loss Statement) with Retained Earnings (on the Balance Sheet)

Net income from the profit and loss statement directly impacts the balance sheet by altering retained earnings in shareholders’ equity. The link is very important and shows how profits or losses change the overall equity. Once dividends are distributed, leftover net income is retained earnings by the company. The company can either reinvest in operations or pay shareholders.

Add PP&E, Depreciation, and Capex to Net Income in Order to Calculate CFFO

Property, Plant, and Equipment (PP&E) and depreciation and capital expenditures (Capex) are required for calculating Cash Flow from Operations (CFFO). Depreciation from the profit and loss statement is a non-cash expense that reduces net income but does not impact cash flow. It requires an adjustment in the cash flow statement.

Capital expenditures, shown in the cash flow statement, affect the balance sheet by altering the PP&E account. This impacts the company’s investment activities and future earnings potential.

Add a Separate Section for “Changes in Net Working Capital” on the Cash Flow Statement

Creating a section for changes in net working capital is a helpful way to understand cash flow from operations. An increase in working capital means the company has invested more in its operations. That reduces free cash flow. A decrease suggests improved liquidity. This section links the balance sheet to the cash flow statement. It shows how the company is handling cash management.

Account for Financing

Financing activities include issuing debt, repaying debt, equity transactions, and paying dividends—all of which affect both the balance sheet and the cash flow statement. These activities offer insights into how the company can finance the future and potential growth.

Find the Closing Cash Balance

The closing cash balance is found on the cash flow statement and must match the cash and cash equivalents reported on the balance sheet. This figure is the culmination of all operating, investing, and financing activities. It reflects the liquidity status at the end of the period. Making sure these figures align is very important for the accuracy of financial models and the overall integrity of financial reporting.

Related: Balance Sheet vs. Income Statement

In Summary: How Are the Three Financial Statements Linked?

A balance sheet, profit and loss statement, and cash flow statement are fantastic indicators of a business’s performance. When jointly analyzed, you can gauge the direction your business is heading and reveal trends that might prompt you to shift priorities moving forward. Not only that but regularly updating and linking your three major financial statements together allows shareholders and potential investors easy access to performance insights. Ultimately, this reflects well on you as the business owner, exhibiting organization and a necessary determination to fully understand the ins and outs of your finances.

How Are the Three Financial Statements Linked FAQs

Below are some of the most commonly asked questions about linking the three essential financial statements together.

What is the most important financial statement?

Importance may vary depending on the stakeholder’s perspective. Each statement offers unique insights. Investors might prioritize the profit and loss statement for profitability and growth potential. Creditors could lean toward the balance sheet for assessing liquidity and solvency. Management often relies on the cash flow statement to understand the operational costs and cash management.

How does depreciation affect the financial statements?

Depreciation impacts what financial statements display in several ways. For the profit and loss statement, depreciation is an expense and reduces net income. On the balance sheet, depreciation decreases the net book value of assets. And on the cash flow statement, depreciation is added back to the net income since it’s a non-cash expense.

What is financial modeling?

Financial modeling is the process of creating a summary of a company’s expenses and earnings that can be used to calculate future decisions. With information from the three major financial statements, you can create a financial model to forecast your company’s future financials based on historical data.

How do you create financial models?

Creating financial models requires several steps:

• Gathering Historical Information: Compile data from financial statements.
• Making Assumptions: Define assumptions about future conditions affecting the company’s performance.
• Forecasting Performance: Use the historical data and assumptions to project future income statement, balance sheet, and cash flow statement outcomes.
• Linking Statements: Ensure that the projections on the profit and loss statement, balance sheet, and cash flow statement are interconnected.
• Analysis: Use the model to analyze the effects of different scenarios and decisions on the company’s financial health.