How the three financial statements connect

One business, three views

Most people learn the three main financial statements one at a time: the income statement, the balance sheet and the statement of cash flows. Grant's video on this topic makes the opposite point. They are not three separate reports. They are three views of one business, and they are built to fit together.

The way they fit comes from what each one measures. The balance sheet is a picture of the business at one moment: what it owns, what it owes, and the owners' share. The other two cover a period, the time between two balance sheets. A business sells, spends, hires, borrows and invests during that period, and the balance sheet at the end differs from the one at the start. The income statement and the statement of cash flows each explain part of that difference.

• The income statement explains how the business performed: revenue minus expenses gives net income. That net income is the main reason equity changed.
• The statement of cash flows explains why cash changed, in three sections: operating, investing and financing.

A complete set of financial statements also includes a fourth, the statement of shareholders' equity, which shows every change in equity. This page leaves it aside, as the video does, because in Northgate's simple year (no new owner money, no dividends, no other comprehensive income and no other adjustments recorded directly in equity) its only change is net income. Other businesses and other years can have those changes, and the statement of shareholders' equity is where they show.

A worked example

This example is hypothetical. Its income statement and cash flow totals follow the example in Grant's video. Northgate Landscaping keeps its books on a calendar year. On January 1 its balance sheet shows $60,000 of cash, $50,000 that the owners put in, and $10,000 of profit kept from earlier years (retained earnings). During the year:

• It completes jobs worth $150,000. Customers pay $140,000 of it by December 31. The other $10,000 is still owed, so accounts receivable rises from $0 to $10,000.
• In January it buys equipment for $50,000 in cash. The equipment is expected to last 10 years with nothing left at the end, so depreciation is $50,000 ÷ 10 = $5,000 a year.
• Its other expenses (wages, fuel, supplies) are $115,000. It pays $105,000 of them during the year. December's $10,000 of supplier bills are unpaid, so accounts payable rises from $0 to $10,000.
• On December 31 it borrows $40,000 from a bank for next season. Because the loan starts on the last day of the year, it carries no interest for this year.

The income statement

Expenses total $120,000, so net income is $150,000 − $120,000 = $30,000. Where does the $30,000 go? To two places at once.

Link 1: net income goes to equity

Net income belongs to the owners. Revenue increases equity and expenses decrease it, as why revenue and expenses change equity shows, so their difference ends up in retained earnings, the part of equity that profit builds. With no dividends, retained earnings rise by exactly the net income.

1. Retained earnings, January 1$10,000
2. Net income for the year, from the income statement+$30,000

   Northgate paid no dividends this year.

3. Retained earnings, December 31$40,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Both ends are on the balance sheet. The middle line is the bottom of the income statement.

Link 2: net income starts the operating cash flow

The $30,000 is not $30,000 of cash. It was measured on the accrual basis: revenue when the jobs were done, expenses when they were incurred. The statement of cash flows starts from it and removes what did not move cash this year, which is the indirect method. The indirect method page derives each adjustment. Here there are three.

1. Net income$30,000
2. Add back depreciation+$5,000

   Reduced net income. Paid no cash this year.

3. Subtract the increase in accounts receivable−$10,000

   Revenue in net income that customers have not paid yet.

4. Add the increase in accounts payable+$10,000

   Expenses in net income that Northgate has not paid yet.

5. Cash from operating activities$35,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Ties to the cash itself: $140,000 collected from customers − $105,000 paid for expenses = $35,000.

Depreciation is added back because it reduced net income without paying cash this year. The equipment's cash left in January, and it is reported once, in investing. The $10,000 of uncollected revenue is subtracted, and the $10,000 of unpaid bills is added. Counting the cash itself gives the same answer: $140,000 collected − $105,000 paid = $35,000.

Link 3: the cash flow statement ends at balance sheet cash

Buying the equipment is an investing activity. Borrowing is a financing activity. Neither is an expense, so neither touches net income. Adding all three sections to the opening cash gives the closing cash.

1. Cash, January 1 (opening balance sheet)$60,000
2. Operating activities+$35,000
3. Investing activities: equipment bought−$50,000
4. Financing activities: bank loan received+$40,000
5. Cash, December 31 (closing balance sheet)$85,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

Net change in cash: $35,000 − $50,000 + $40,000 = $25,000.

The statement of cash flows has no cash figure of its own at the end. Its last line is the cash on the December 31 balance sheet, and its first is the cash on the January 1 balance sheet.

The balance sheet at both ends

Both columns balance: $60,000 = $0 + $60,000, and $140,000 = $50,000 of liabilities + $90,000 of equity. The last column is the whole system on one page. Every change on Northgate's balance sheet is explained by a line on one of the other two statements, and no line on them is left over. That works here because the example states the transaction behind each change.

Why the statements must tie

The links are not conventions that someone chose. They follow from the accounting equation, which holds on both balance sheet dates.

Split the assets into cash and everything else. Then cash = liabilities + equity − non-cash assets. That is true on January 1 and on December 31, so it is also true of the change:

Change in cash = change in liabilities + change in equity − change in non-cash assets.

For Northgate: $50,000 (payables and the loan) + $30,000 (equity) − $55,000 (receivables and equipment) = $25,000, the change in cash. The statement of cash flows is this equation with each term written out and sorted into operating, investing and financing. In Northgate's year the change in equity is just net income, because no owners put money in or took it out and nothing else, such as other comprehensive income, was recorded directly in equity. That is why net income is its first line here. A business with other equity changes has more terms in the same equation.

So the ties are checks. If the cash flow statement's ending cash differs from the balance sheet, one of the statements is wrong. In a year like Northgate's, with no direct adjustments to retained earnings, the same is true if retained earnings do not roll forward by net income less dividends. Some companies do record direct adjustments, such as the correction of a prior-period error, so for them a difference has to be explained before it is called an error.

A common misconception

The usual mistake is to read the $30,000 of net income as $30,000 of new cash, or to expect retained earnings and cash to move together. Northgate's retained earnings rose by $30,000 and its cash rose by $25,000. Cash rose for different reasons: $35,000 from operations, less $50,000 of equipment, plus a $40,000 loan. Retained earnings are a part of equity, a claim on all the assets. They are not a pile of cash.

A second mistake is to treat the statement of cash flows as a separate record kept from the bank account. In this simplified example it can be built from the income statement and the two balance sheets, as the table above shows, because the example also states the transactions behind each change: the equipment was paid in cash, the loan was received in cash, and the receivables and payables are uncollected sales and unpaid bills. Two balance sheets alone show only net changes, and the same net change can come from different cash flows, or from none: equipment bought on credit from the seller, or separate borrowings and repayments that net to one figure. Real preparation therefore also uses the underlying records and the notes to separate cash flows from noncash changes and to find the gross flows and their classification. The ties still hold, which is why analysts build the three statements together and check that the balance sheet still balances.

Where this stops

• The example has no dividends, interest, income taxes or inventory. With dividends, retained earnings rise by net income minus dividends, and the dividends paid appear in financing. The other items add lines under the same rules.
• Real statements reconcile cash and cash equivalents, and their cash flow statements carry more lines. Classification has detailed rules in ASC 230 that this page does not cover.
• The statement of shareholders' equity, the fourth statement, is not shown here.
• This page follows US GAAP presentation. IFRS is not covered here.