Understanding how the Three Financial Statements link together
While it is critical to understand the income statement, balance sheet, and cash flow statement on their own, it is also critical to understand how the three financial statements work in conjunction with one another.
Financial modelling takes up a significant amount of time for analysts working in investment banking, corporate mergers and acquisitions, and private equity. Business and asset performance can be predicted using financial models, which are simplified representations of the underlying data. They can assist in determining, among other things, how a business is expected to develop in the future, what a fair price for the enterprise or asset would be, and what capital requirements the company may encounter.
Having said that, a financial model must include financial statements that are properly linked to one another as well as a balancing balance sheet. Furthermore, financial analysts must be familiar with the concept of circularity in a financial model.
The section below will provide you with an easy-to-understand overview of the relationship between the three financial statements.
1) Net Income and Retained Earnings
A company's net income is the bottom line of its income statement. It is the amount left over after subtracting all of the expenses incurred by a business from the revenue generated.
At the same time, net income is the first line item on the cash flow statement for operating cash flow, which is the first item in the operating cash flow. Using the operating cash flow, you can determine how much of your net income was collected in cash.
n addition, the remaining portion of net income that was not distributed to shareholders in the form of dividends will be deposited in retained earnings on the balance sheet. Given that retained earnings is a balance, it represents the sum of all of the company's past net incomes or losses, less any dividends paid to shareholders.
2) Depreciation, Amortization and Property, Plant and Equipment
Write-offs of tangible (depreciation) and intangible (amortization) assets are referred to as D&A. They operate on the premise that assets depreciate in value over time. As a result, tangible assets (goodwill, patents, trademarks) decrease in value by the amount of depreciation recorded on the balance sheet, while intangible assets (goodwill, patents, trademarks) decrease in value by the amount of amortization.
However, even though PP&E and intangibles decrease as a result of D&A, they can increase during the same period as a result of investment in new machines, real estate and patents, among other things. This means that the PP&E for the current period is the sum of the previous period's PP&E plus investments, less depreciation for the current period.
Costs of goods and services (D&A) are accounting costs that pass through the income statement and reduce net income. Nevertheless, because D&A has no effect on cash flow, it must be added back to net income in the operating cash flow section of the cash flow statement.
3) Operating Working Capital
It is defined as the difference between noncash current assets and noninterest-bearing current liabilities, less noncash current liabilities.
An increase in non-cash current assets, such as accounts receivables and inventory, represents a sapping of available cash resources. Because a customer has not yet paid, or because the company purchased materials and goods with the intent of manufacturing products, this occurs. In the opposite direction, a decrease in these assets indicates that the company has depleted its inventory of raw materials or received cash payments from customers, resulting in the release of cash.
With regard to the company's current liabilities, an increase in accounts payable indicates that the company has received goods but has not yet paid for them, indicating that the activity is not one that generates cash. As an alternative, a decrease in accounts payable indicates that the company has paid invoices and has therefore used up its cash reserves.
4) Debt Repayment
The majority of the time, when a company issues debt, such as in the form of loans, it is required to repay that debt through regular principal and interest payments. For the sake of simplicity, we will assume that there is no interest charged on the loan. Otherwise, things would become quite complicated.
In the event that a company takes on debt, the amount of investing cash flow will increase by the amount of debt taken on. If, on the other hand, it repays the loan, the amount of investing cash flow is reduced by the amount of the loan principal until the loan is repaid.
Parallel to this, the balance position known as "long-term debt" increases or decreases by the amount raised or repaid, depending on the situation.
5) Total Change of Cash
It is the final item on the cash flow statement that represents the total change in cash for the company during that period. This item is calculated as the sum of the operating, investing, and financing cash flows. The total change in cash flows from the cash balance on the balance sheet to the cash balance on the balance sheet.
6) Circular Reference of the Three Financial Statements
A three-statement financial model that is properly linked will always have a circularity in it.
The issuance or repayment of debt is typically the point at which the circular reference begins in the debt schedule.
In the event that a company takes on additional debt, the amount of principal payments and interest expenses that the company is responsible for increase. The higher interest expense will flow through the income statement and into the financial result, which will have the effect of decreasing net income by a significant amount. The lower net income will then flow into the cash flow statement, reducing the amount of cash available for use before debt repayments is due to be made. The lower cash flow prior to debt payments will then flow back into the debt schedule, reducing the possibility of principal debt repayment in the future..
If we have less cash available, we will be able to repay less of our debt, which will result in higher interest payments, which will reduce net income, which will lower cash flow before debt repayment, and the cycle will repeat itself.
Frequently Asked Questions (FAQ)
What is the purpose of linking the financial statements?
Linking the financial statements allows for a comprehensive analysis of a company's financial performance and position. It helps stakeholders understand how net income flows into the balance sheet and how it is adjusted in the cash flow statement, providing insights into profitability, liquidity, and solvency.
How does net income from the income statement affect the balance sheet?
Net income increases the retained earnings section of the balance sheet. Retained earnings represent the accumulated profits that have not been distributed to shareholders as dividends, contributing to shareholders' equity.
How is net income adjusted in the cash flow statement?
Net income from the income statement serves as a starting point for the operating activities section of the cash flow statement. Adjustments are made to reflect the actual cash flows, such as adding back non-cash expenses (e.g., depreciation, amortization) and incorporating changes in working capital items (e.g., accounts receivable, accounts payable).
Why is the cash flow statement important?
The cash flow statement provides insights into a company's cash generation and utilization. It highlights the sources and uses of cash from operating, investing, and financing activities, helping evaluate a company's ability to generate cash, its investment decisions, and its financing activities.
How do the financial statements work together for financial analysis?
Financial analysis involves examining the relationships between the financial statements. The income statement shows the company's revenues, expenses, and net income. The balance sheet presents the financial position, including assets, liabilities, and shareholders' equity. The cash flow statement complements the other statements by providing information on cash flows. By analyzing these statements collectively, one can assess the company's profitability, liquidity, and overall financial health.
Are there any limitations to the financial statements' linkages?
While the linkages between the financial statements provide valuable insights, they have certain limitations. The statements are based on accounting principles and estimates, which may affect their accuracy. Additionally, non-cash items, timing differences, and other factors can impact the relationships between the statements. Therefore, it's important to consider additional factors and perform a thorough analysis when interpreting the financial statements.
Are there any other financial statements apart from the three mentioned?
The income statement, balance sheet, and cash flow statement are the primary financial statements. However, some companies may also prepare a statement of changes in shareholders' equity, which provides details on the changes in shareholders' equity over a period.