How Are the Three Financial Statements Linked in Accounting?

Businesses report their financial information through three standardized statements: the income statement (IS), the balance sheet (BS) and the cash flow statement (CFS). The IS shows revenue, expenses and net income over a specific time period. The BS gives you a snapshot of a company’s assets, liabilities and equity at a specific point. The CFS illustrates a business’s liquidity by showing its cash transactions during the accounting period.¹

These major financial statements help investors, shareholders, regulatory agencies and other interested parties understand the company’s performance and make informed decisions.¹

Each statement covers a different aspect of an organization’s financial performance. Though they’re reported separately, the information in each statement influences the others. If you don’t understand how the data from one flows into the other, your analysis and modeling will be incomplete or inaccurate.¹

This article will explore how the three financial statements are linked and why it matters when you’re building financial models.

Key Linking Mechanics

Being able to link a line item on one report to an item on another report can give you more insight than analyzing each statement on its own. You need to understand how they connect to build a three-statement model, which projects future financial performance:²

• Net income, the final line on the IS, serves as the top line of the CFS and is reported as part of retained earnings on the BS
• Depreciation and other non-cash charges are added back in on the CFS to reconcile net income with actual cash flow. These line items reduce the value of assets and increase accumulated depreciation on the BS
• Capital expenditures are reported as investing cash outflow on the CFS and increase the property, plant and equipment (PP&E) line on the BS
• Changes in working capital are reported in the operating section of the CFS by increasing or reducing cash. This change affects current assets and liabilities on the BS
• Financing activities, such as debt, equity or repayment, are reported in the financing section of the CFS. They affect the liability and equity accounts on the BS
• The ending cash balance is the last item on the CFS and is reported on the cash line under current assets on the BS

Step-by-Step Walk-Through

To build your three-statement model, begin with income statement assumptions, which drive revenue, costs and profitability. Use historical data to project this data, including revenue growth, cost of goods and operating expenses, depreciation and amortization, interest expenses and taxes.³

Next, build the CFS starting from the net income from the IS. Add in operating, investing and financing activities. The result will be the net change in cash, which you can input on the BS. Finally, update the BS and ensure the assets equal liabilities plus equity.³

Common Pitfalls and How to Avoid Them

When you first begin building three-statement models, it’s easy to overlook certain issues. Here are some common mistakes analysts often encounter.

Circular References With Interest Expenses

A circular reference occurs when the input of an entry depends on the output of that entry. In Excel, this can break your model. It most often occurs when you project your interest expense based on the average debt balance, which depends on cash flow from operations. However, this entry is affected by the interest expense, creating a circular reference.⁴

To avoid this, calculate interest expenses using the beginning balance instead of the average balance. You can build a toggle switch into your model that lets you switch from average balance to beginning balance to avoid circular references.⁴

Ignoring Non-Cash Gains and Losses

If your model doesn’t account for gains and losses on non-cash items, such as selling an asset for a different price than its book value, it won’t be accurate. These entries are not listed as cash gains or losses because they’re based on assets from prior periods. To correct this error, identify non-cash gains and losses on the IS and account for them in the operating section of the CFS.⁵

Misclassifying Financing vs. Operating Cash Flows

It’s easy to accidentally list financing expenses under operating expenses or vice versa. This is such a common error that the Securities and Exchange Commission (SEC) recently announced that it is a leading cause of problems with financial statements.⁶ The best way to accurately classify cash flow expenses is by carefully referencing the accounting guidelines you’re following and implementing checks, such as a cash flow cheat sheet, to avoid misclassifications.⁷

Best Practices for Analysts

Following standard best practices will make your models easier for others to understand and, therefore, more valuable. However, analysts don’t always agree on standard conventions. For example, there are several ways to indicate whether an item is an expense or income. Using positive numbers for income and negative for expenses may seem clear and logical, but it doesn’t align with public filing conventions. Whatever method you choose, decide on it before you build your model and stick with it.⁸

Implement audit checks to identify errors before your model is shared with decision-makers. You can do this by building flags into your model to signal any unexpected results. Document all assumptions and linkage formulas clearly so they’re transparent and simple for others to follow.⁸

Applications in Real-World Scenarios

Business leaders and other decision-makers use three-statement models for many purposes. They can forecast outcomes for strategic decisions, such as how outsourcing part of the manufacturing process will impact profits. Investors use them to create valuation models for businesses when they’re considering buying equity. Banks and other lenders use financial models to perform credit analyses. Analysts use them to establish realistic budgets and forecast expenses or profits for upcoming accounting periods. They can also use them for risk management by evaluating financial stability and assessing liquidity.³

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