In plain English
There are only three financial statements. The income statement is a film of the year: what came in and what went out. The balance sheet is a photograph on the last day: what the company owns and owes at that instant. The cash flow statement is the bank statement: it explains why the cash line on the photograph moved.
The advanced view
The statements are one articulated system. Net income closes into retained earnings within equity; the change in the cash line on the balance sheet must equal the bottom of the cash flow statement; and the non-cash accruals that separate the two are exactly the working-capital and depreciation adjustments in the operating section. If a model does not tie on both links, it is wrong.
Income statement: covers a period ('for the year ended 31 December'). Balance sheet: covers a moment ('as at 31 December'). Cash flow statement: covers a period again, and reconciles the two. Reading the date line at the top of a statement is the first professional habit to build.
The two links are simple. First: profit that is not paid out as dividends is added to retained earnings inside equity, so a profitable year makes the balance sheet grow. Second: the bottom line of the cash flow statement is the change in the cash line on the balance sheet. If those two do not hold, someone has made a mistake.
The two links
Closing equity = Opening equity + Net income − Dividends Closing cash = Opening cash + Operating + Investing + Financing
Essential vocabulary
- Income statement
- Performance over a period: revenue, costs, profit. Also called profit and loss (P&L).
- Balance sheet
- Position at a single date: assets, liabilities, equity.
- Cash flow statement
- Where cash came from and went during the period, split three ways.
- Retained earnings
- The pile of all past profits not paid out as dividends. Lives inside equity.
- Accrual
- Recording something when it happens rather than when it is paid. The reason profit and cash differ.
Common pitfalls
- ×Comparing a balance-sheet number with an income-statement number without noticing one is a moment and the other a period.
- ×Thinking dividends are an expense. They are a distribution of profit, taken out of equity.
- ×Assuming a growing balance sheet means a healthy company — it can simply mean more debt.
Why it works
The three statements are three views of one set of transactions, so they cannot disagree. Every entry that touches profit also touches the balance sheet, and every entry that touches cash appears in the cash flow statement. That redundancy is the point: it lets you check any single number three different ways.
How it is used — one year, all three statements
Step 1 of 5
- 1Opening: cash 50, equipment 100, debt 60, equity 90.
Deeper
Deeper: the two links that hold the statements together
Only two connections matter, and if you can state them you can build a model. First: net income flows into retained earnings on the balance sheet (less dividends). Second: the cash flow statement's closing cash is the cash line on the balance sheet.
Everything else is plumbing. Non-cash charges (depreciation, amortisation, impairments, share-based pay) are added back in operating cash flow. Changes in working capital are subtracted when assets grow. Capex sits in investing; debt and equity issuance and dividends sit in financing. If the balance sheet does not balance in a model, the error is almost always a missing sign on working capital or a capex line that never reached the asset.
Must know cold
- ✓Assets = Liabilities + Equity, always, at every date.
- ✓Closing equity = opening equity + net income − dividends ± share issues/buybacks.
- ✓Closing cash = opening cash + operating + investing + financing cash flow.
- ✓Depreciation reduces profit and assets but not cash.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Opening cash 40, net income 30, depreciation 15, receivables up 20, capex 25, dividend 10. What is closing cash, and what is the change in equity?
Exercise 2
A machine is written down by 12 (impairment). Trace the effect through all three statements.