How the 3 Financial Statements are Linked (2024)

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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.

How the 3 Financial Statements are Linked (1)

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.

How the 3 Financial Statements are Linked (2)

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.

How the 3 Financial Statements are Linked (3)

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.

How the 3 Financial Statements are Linked (4)

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:

  1. Enter at least 3 years of historical financial information for the 3 financial statements.
  2. Calculate the drivers/ratios of the business for the historical period.
  3. Enter assumptions about what the drivers will be in the future.
  4. 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
How the 3 Financial Statements are Linked (2024)

FAQs

How the 3 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 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.

How do the three financial statements relate to each other? ›

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 ...

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.

What are the three most important financial statements according to this resource link? ›

The three main types of financial statements are the balance sheet, the income statement, and the cash flow statement. 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.

How are the balance sheet and income statement connected? ›

The balance sheet shows the cumulative effect of the income statement over time. It is just like your bank balance. Your bank balance is the sum of all the deposits and withdrawals you have made. When the company earns money and keeps it, it gets added to the balance sheet.

What is a 3 statement financial statement? ›

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.

What is the most important of the three financial statements? ›

A financial statement segments into three divisions; Balance sheet, income statement, and cash flow statement. Among these 3 major financial statements, the most important financial statement is the income statement.

What is the 3 statement financial model? ›

A three-statement financial model is an integrated model that forecasts an organization's income statements, balance sheets and cash flow statements. The three core elements (income statements, balance sheets and cash flow statements) require that you gather data ahead of performing any financial modeling.

How do the four basic financial statements work together? ›

All four accounting financial statements accurately portray the company's overall financial situation. The income statement records all revenues and expenses. The balance sheet provides information about assets and liabilities. The cash flow statement shows how cash moves in and out of the business.

What is the relationship between P&L and balance sheet? ›

The profit and loss (P&L) account summarises a business' trading transactions - income, sales and expenditure - and the resulting profit or loss for a given period. The balance sheet, by comparison, provides a financial snapshot at a given moment.

What are the three financial statements Quizlet? ›

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.

What are the three 3 sections comprising the statement of financial position? ›

As an overview of the company's financial position, the balance sheet consists of three major sections: (1) the assets, which are probable future economic benefits owned or controlled by the entity; (2) the liabilities, which are probable future sacrifices of economic benefits; and (3) the owners' equity, calculated as ...

How are the four primary financial statements linked? ›

The statement of cash flows takes some of its information from the balance sheet and the income statement. Balance sheet cash transactions are transferred to the statement of cash flows.

What is the relationship between balance sheet and profit and loss account? ›

The profit and loss (P&L) account summarises a business' trading transactions - income, sales and expenditure - and the resulting profit or loss for a given period. The balance sheet, by comparison, provides a financial snapshot at a given moment.

What is the basic 3 statement financial model? ›

A three-statement financial model is an integrated model that forecasts an organization's income statements, balance sheets and cash flow statements. The three core elements (income statements, balance sheets and cash flow statements) require that you gather data ahead of performing any financial modeling.

How does a $10 increase in depreciation affect the three financial statements? ›

Answer: Income Statement: Operating Income would decrease by $10. If we assume a 40% tax rate, Net Income would decrease by $6. Cash Flow Statement: Net Income is down by $6, but the $10 of Depreciation gets added back because it is a non-cash expense.

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