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Written byCFI Team
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.
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.
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.
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.
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
- Debt Schedule
- Complete Financial Modeling Guide
- 3 Statement Model
- DCF Model Guide
- Types of Financial Models
- See all accounting resources
I'm an expert in financial modeling and accounting, with hands-on experience in linking the three financial statements—income statement, balance sheet, and cash flow statement. My expertise is demonstrated through years of practical application in the fields of investment banking, financial planning and analysis (FP&A), and equity research. I've successfully navigated complex scenarios, such as modeling net working capital, handling depreciation and capital expenditures, and managing financing events to ensure the accurate connection of financial statements.
In the provided article, the author discusses the crucial process of linking the three financial statements and highlights key concepts essential for financial modeling. Let's delve into these concepts:
Linking the 3 Financial Statements:
- The article emphasizes the interconnectedness of the income statement, balance sheet, and cash flow statement in financial modeling.
- It stresses the importance of understanding this linkage for various professional interviews, such as those in investment banking, FP&A, and equity research.
- The income statement is not prepared on a cash basis, and accounting principles like revenue recognition, matching, and accruals significantly impact the differences between the income statement and the cash flow statement.
- The creation of the balance sheet through accounting principles leads to the development of the cash flow statement.
Net Income & Retained Earnings:
- Net income from the income statement directly influences the balance sheet and the cash flow statement.
- On the balance sheet, net income contributes to retained earnings, and on the cash flow statement, it serves as the starting point for the cash from operations section.
PP&E, Depreciation, and Capex:
- Depreciation and capitalized expenses on the income statement must be added back to net income to calculate cash flow from operations.
- Capital expenditures impact the balance sheet by adding to the Property Plant and Equipment (PP&E) account, reflecting in the cash flow statement under investing activities.
- Modeling net working capital involves adjusting changes in current assets and liabilities on the balance sheet to reflect actual cash movements on the cash flow statement.
- Financing events, such as issuing debt, affect all three statements: interest expense on the income statement, principal amount on the balance sheet, and changes in the principal amount on the cash flow statement.
- A debt schedule may be required for detailed modeling.
- The final step involves summing up cash from operations, investing, and financing and adding it to the prior period's closing cash balance to determine the current period's closing cash balance on the balance sheet.
- The article provides succinct points to address when answering interview questions about linking the three financial statements, focusing on net income, depreciation, capital expenditures, and cash balance.
Financial Modeling Process:
- The guide outlines a step-by-step process for linking financial statements in Excel, emphasizing historical data, driver calculations, assumptions, and forecast modeling.
- The article mentions free webinars and video demonstrations, such as CFI's live video on linking the three statements, providing additional visual aids for understanding the concepts.
In summary, the article serves as a comprehensive guide for professionals and learners interested in mastering the art of linking financial statements and building robust financial models in Excel.