The Three Major Financial Statements: How They’re Interconnected

The balance sheet tells you what you own, what you owe, and what’s left over. In other words, your company’s balance sheet shows you your current assets, current liabilities, and owner’s equity (or shareholders equity if you’re a corporation). That information tells you what your company is worth at a specific point in time. The company’s management team uses both the balance sheet and the income statement to gauge its financial health. Companies’ management teams use the balance sheet to gauge if the company has enough liquid assets to meet its pressing financial obligations.

Net income from the income statement flows into the balance sheet as a change in retained earnings (adjusted for payment of dividends).
These assets get listed first on the balance sheet before any other classification.
When analyzed over time or comparatively against competing companies, managers can better understand ways to improve the financial health of a company.

This can shine a light on areas where profitability is compromised or low, and lead management to make strategic changes in the company’s business model to address them (such as price changes). By subtracting all your expenses from your revenues, you get your net income (also known as the bottom line.) This is the money you keep as profit. Consequently, when reviewing the financial statements of an organization, one should examine all of the financial statements in order to obtain a complete picture of its financial situation. This entry derecognizes the interest receivable in the balance sheet and recognizes cash or bank that entity receives the payment of interest.

That’s to say, the total assets always stayed equal to the total of capital and liabilities. Although the balance sheet and income statement have their differences, they still have things in common. Creditors and investors use them to decide whether they want to be involved financially in a company or not.

Main Purposes of Financial Statements (Explained)

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Watch CFI’s live video demonstration of linking the statements together in Excel. In some situations, the term and conditions in the contract required interest to be paid for more than 12 months. Since this is the journal entry when the company recognizes interest income while the payment is not received yet. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

For this section of linking the 3 financial statements, it’s important to build a separate depreciation schedule.
That’s because a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholder equity).
Balance sheets should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing.
For some companies, it can be monthly, for some quarterly, and others annually.
In this example, Apple’s total assets of $323.8 billion is segregated towards the top of the report.

Revenue, including non-operating income, is $842,000 ($834,000 net sales + $5,000 interest income + $3,000 other income). Management, investors, shareholders and others use it to assess the performance and future prospects of a business. Investors and lenders use it to determine creditworthiness and availability of assets for collateral.

Net income at the end of a period becomes part of the company’s stockholders’ equity as retained earnings. Net income is also carried over to the cash flow statement where it serves as the top line item for operating activities. Sales booked during the period are also added to the company’s short-term assets as accounts receivable. The income statement is a financial statement that shows a company’s revenues, expenses and profit for a given period of time.

The cash flow statement displays the change in cash per period, as well as the beginning and ending balance of cash. 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). On the income statement, analysts will typically be looking at a company’s profitability. Therefore, key ratios used for analyzing the income statement include gross margin, operating margin, and net margin as well as tax ratio efficiency and interest coverage.

Now we can see the full flow of information from the income statement to the statement of retained earnings (Figure 5.10) and finally to the balance sheet. Clear Lake’s net income flows from the income statement into retained earnings, which is reflected on the statement of retained earnings. It’s the creation of the balance sheet through accounting principles that leads to the rise of the cash flow statement. 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. The income statement helps creditors and lenders determine if a company is generating enough profit to handle its liabilities.

What Are the Uses of a Balance Sheet?

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. The last expenses to be considered here include interest, tax, and extraordinary items. The subtraction of these items results in the bottom double entry accounting line net income or the total amount of earnings a company has achieved. In this tutorial, we will break it down for you step-by-step, although we assume you already have a basic understanding of accounting fundamentals and know how to read financial statements. Did you notice how the balance sheet remained in balance after every transaction?

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. If you want to see a video-based example, watch CFI’s webinar on linking the 3 statements. In this section, it’s often necessary to model a debt schedule to build in the necessary detail that’s required. The remaining amounts are unpaid at the end of the year and are expected to be paid within 12 months.

Cash Flow Statement

The latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price. A liability is any money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds issued to creditors to rent, utilities and salaries. Current liabilities are due within one year and are listed in order of their due date.

How confident are you in your long term financial plan?

All three accounting statements are important for understanding and analyzing a company’s performance from multiple angles. The income statement provides deep insight into the core operating activities that generate earnings for the firm. The balance sheet and cash flow statement, however, focus more on the capital management of the firm in terms of both assets and structure. 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.

The information contained in the periodic financial statements is supplemental to the information contained in the balance sheet, so it is reasonable to expect some interconnection between them. That’s because a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholder equity). Average inventory is found by dividing the sum of beginning and ending inventory balances found on the balance sheet. The beginning inventory balance in the current year is taken from the ending inventory balance in the prior year.

The income statement shows you how profitable your business is over a given time period. This is recorded as revenue on its income statement, and increases shareholders’ equity on the balance sheet by the same amount. Big Apple then pays the daily wages of a warehouse worker, which appears as a $200 expense on its income statement and reduces shareholders’ equity on the balance sheet by the same amount. Finally, the company finds that one bushel of apples is rotten, and writes off its value; this is a $40 loss on the income statement and a $40 reduction of shareholders’ equity on the balance sheet.

The income statement reflects the fact that the business sold goods costing 500 for 800 and made a profit of 300. This increase is the same as the movement in equity between the opening and closing balance sheets, as shown in the diagram below. A company can use its balance sheet to craft internal decisions, though the information presented is usually not as helpful as an income statement. A company may look at its balance sheet to measure risk, make sure it has enough cash on hand, and evaluate how it wants to raise more capital (through debt or equity).

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In order to do this, we create a separate section that calculates the changes in net working capital. The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. Together the three statements give a comprehensive portrayal of the company’s operating activities. This means that a company’s income statement and balance sheet must balance out.

The holiday season is often hailed as the most wonderful time of the year, but for small businesses or e-commerce store, it can also be the busiest and most… That same company should make international payments as seamless as possible so that everyone gets paid in their desired currency as quickly as possible. Consistent monitoring and analysis can help uncover financial distress before it severely impacts the business.