Step-by-step guide
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How are the 3 Financial Statements Linked?
The 3 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. See CFI’s freeinterview guides to learn more.
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.
Want to see a live demonstration? Watch CFI’s free webinar on how to link the 3 financial statements in Excel.
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 statement 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.
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 Property Plant and Equipment (PP&E) onto the income statement as an expense, and then gets added back in the cash flow statement.
For this section of linking the 3 financial statements, it’s important to build a separate depreciation schedule.
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
Modeling net working capital can sometimes be confusing. Changes in current assets and current liabilities on the balance sheet are related to revenues and 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. In order to do this, we create a separate section that calculates the changes in net working capital.
Financing
This can be a tricky part of linking the three statements and requires some additional schedules. Financing events such as issuing debt affect all three statements in the following way: the interest expense appears on the income statement, the principal amount of debt owed sits on the balance sheet, and the change in the principal amount owed is reflected on the cash from financing section of the cash flow statement.
In this section, it’s often necessary to model a debt schedule to build in the necessary detail that’s required.
Cash Balance
This is the final step in linking the 3 financial statements. Once all of the above items are linked up properly, the sum of cash from operations, 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.
This is the moment of truth when you discover whether or not your balance sheet balances!
How to Answer the Question in an Interview
If you get an interview question along the lines of, “How are the 3 financial statements linked together?” in an interview you shouldn’t go into as much detail as above, but instead simply hit the main points, which are:
- Net income from the income statement flows to the balance sheet and cash flow statement
- Depreciation is added back and CapEx is deducted on the cash flow statement, which determines PP&E on the balance sheet
- Financing activities mostly affect the balance sheet and cash from finalizing, except for interest, which is shown on the income statement
- The sum of the last period’s closing cash balance plus this periods cash from operations, investing, and financing is the closing cash balance on the balance sheet
If you want to see a video-based example, watch CFI’swebinar on linking the 3 statements.
How to Link the Financial Statements 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:
- Enter at least 3 years of historical financial information for the 3 financial statements.
- Calculate the drivers/ratios of the business for the historical period.
- Enter assumptions about what the drivers will be in the future.
- Build and link the financial statements following the principles discussed above.
The model essentially inverts, where the historical period is hardcoded for the statements and calculations for the drivers, and then the forecast is hardcodes for the drivers and calculations for the financial statements.
Check out CFI’s step-by-step courses to learn how to build financial models in Excel.
Video of Linking the 3 Statements
Watch CFI’s live video demonstration of linking the statements together in Excel.
More Financial Resources
We hope this has been a helpful guide on How the 3 Financial Statements are Linked Together. To keep learning more, please check out these relevant CFI resources:
- Free Cash Flow
- EBITDA
- Debt Schedule
- Complete Financial Modeling Guide
- 3 Statement Model
- DCF Model Guide
- Types of Financial Models
- See all accounting resources
FAQs
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.
How are the three financial statements linked interview questions and answers? ›
Net income which is profit before tax less tax expense is connected on all three financial statements. Net income is located at the bottom of the income statement and directly at the top of the cash flow statement followed by cash from operations. On the balance sheet, net income feeds into retained earnings.
What are the 3 financial statements and why are they linked? ›
The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.
How financial statements are interlinked to each other? ›
In summary, net income from the income statement flows to the top of the cash flow statement, which flows into the bottom of the balance sheet as retained earnings. Net income also impacts cash, which is reported at the bottom of the cash flow statement, which then flows into the top of the balance sheet.
How are the three financial statements linked in Quizlet? ›
How are the three financial statements linked? The Income Statement is linked to the Balance Sheet and Statement of Cash Flows through Net Income. Net Income flows to the Balance Sheet through the Retained Earnings account within Shareholders' Equity.
How do you answer how the financial statements are linked? ›
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.
How do the three statements link together in an interview answer? ›
The major links in the three financial statements are: Net income from the IS links to the BS (retained earnings) and the CFS operating section. Property, plant and equipment in the BS creates depreciation in the IS and the CFS operating section, and also creates capital expenditure in the CFS investing section.
Why do you need all 3 financial statements? ›
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.
How is the statement of cash flows linked to each of the other financial statements? ›
The cash flow statement is linked to the income statement by net profit or net burn, which is the first line item of the cash flow statement. The profit or loss on the income statement is then used to calculate cash flow from operations. This is referred to as the indirect method.
What is the 3 financial statement exercise? ›
In a 3-statement model, you input the historical versions of these statements and then project them over a ~5-year period. In real life, you do this to value companies, model transactions, and determine whether the company's expected growth, margins, and cash flow metrics are plausible.
The net income figure in the income statement is added to the retained earnings line item in the balance sheet, which alters the amount of equity listed on the balance sheet. The net income figure also appears as a line item in the cash flows from operating activities section of the statement of cash flows.
What are the 4 financial statements and how they connect with each other? ›
They are: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders' equity. Balance sheets show what a company owns and what it owes at a fixed point in time. Income statements show how much money a company made and spent over a period of time.
How recognition links the elements of financial statements? ›
Recognition of elements of financial statements: Involves establishing criteria for accounting and reporting data related to the elements. This process is guided by principles like the Economic Entity Principle, Monetary Unit Principle, Periodicity Principle, and Going Concern Principle.
What are the three 3 standard financial statements and describe how they relate to one another? ›
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.
What is common in all three financial statements? ›
These three statements together show the assets and liabilities of a business, its revenues, and costs, as well as its cash flows from operating, investing, and financing activities.
Which of the three financial statements are most important? ›
Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.
How are the three financial statements linked interview questions in WSO? ›
Interview Question – Example Response
“The bottom line of the income statement is net income, the accrual based profit metric, inclusive of all operating and non-operating costs. Net income flows in as the starting line item on the cash flow statement, which is reconciled in the cash flow from operations section.
What questions do the three main financial statements answer? ›
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.
What type of questions do the financial statements help to answer? ›
It answers several other questions like is the present cash flow enough to serve the principal payments and interest to cover the borrowing needs of the company? Should the current investments be liquidated? Would the investments put in place bring forth good returns?
What are the three 3 main components of the statement of financial position describe each component? ›
The three main components of the statement of financial position are assets, liabilities, and equity, which are broken down into various categories. However, the way in which the statement is presented varies from company to company, depending on the types of assets, liabilities, and equity they have.
