The Three Statements

How the income statement, balance sheet, and cash flow link

Finance FundamentalsFinancial Statements & RatiosFree preview

⏱️ About 16 min

Three reports, one company. The income statement, the balance sheet, and the cash flow statement are not separate stories - they are three views of the same set of transactions, wired together by a few hard links.

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The big idea: The income statement measures profit over a period: revenue minus expenses equals net income. The balance sheet is a snapshot where assets equal liabilities plus equity. The cash flow statement explains the change in cash. The links are rigid: net income adds to retained earnings inside equity, and it is also the starting line of the cash flow statement, whose ending cash must equal the cash line on the balance sheet.

🎯 By the end, you'll be able to

State what each of the three statements measures.
Trace net income into retained earnings and into cash flow from operations.
Roll retained earnings and cash forward for one period.

📎 Helpful to know first

Comfort with basic arithmetic; no accounting background needed.

Three views of one business

The income statement covers a period of time and answers one question: was the company profitable? Revenue minus all expenses (including depreciation) is net income. The balance sheet is a snapshot at a single instant, and it always obeys the accounting identity $\text{Assets} = \text{Liabilities} + \text{Equity}$. The cash flow statement bridges two balance-sheet snapshots by explaining exactly why cash rose or fell.

The links that tie them together

Net income does not vanish. It is added to retained earnings inside equity: $\text{RE}_{end} = \text{RE}_{begin} + \text{Net income} - \text{Dividends}$. That same net income is the top line of the cash flow statement under the indirect method, which then adds back non-cash charges like depreciation, subtracts the increase in working capital, and nets investing and financing flows. The ending cash it produces must match the cash reported on the balance sheet - if it does not, the statements do not tie.

\[ \text{RE}_{end} = \text{RE}_{begin} + \text{Net income} - \text{Dividends} \qquad \text{Cash}_{end} = \text{Cash}_{begin} + \text{CFO} + \text{CFI} + \text{CFF} \]

Cash flow from operations, indirectly

Under the indirect method, cash flow from operations starts at net income, adds back depreciation (an expense that moved no cash), and subtracts the increase in net working capital (cash tied up in receivables and inventory). Investing cash flow is dominated by capital expenditure; financing cash flow includes dividends and borrowing. The three subtotals sum to the change in cash.

⚠️ Profit is not cash

A company can report healthy net income and still run out of cash if profit is locked up in unpaid invoices or unsold inventory. That is precisely why the cash flow statement exists: it strips accrual accounting back to the cash that actually moved.

🎮 Three-Statement Linkage Explorer LIVE

Predict first: Predict first: if depreciation rises but everything else is held fixed, what happens to net income, and what happens to cash flow from operations?

Set revenue, expenses, depreciation, the working-capital change, capex, and dividends; the model rolls net income into retained earnings and into cash flow, and reports ending cash.

📝 Worked example: A firm reports revenue of $500 and total expenses of $420 (which already include $30 of depreciation). Retained earnings began at $200 and cash began at $50. Working capital rose by $15, capex was $40, and dividends were $20. Find net income, ending retained earnings, and ending cash.

1. Net income: $500 - 420 = \$80$.
2. Retained earnings: $200 + 80 - 20 = \$260$.
3. Operating cash flow: $80 + 30 - 15 = \$95$; investing $= -40$; financing $= -20$.
4. Ending cash: $50 + 95 - 40 - 20 = \$85$.

✓ Net income = $80; ending retained earnings = $260; ending cash = $85

✏️ Practice: Revenue is $600 and expenses are $540 (including $25 depreciation). Retained earnings began at $150, cash at $60. Working capital fell by $10 (a $10 source of cash), capex was $30, dividends were $15. Find net income, ending retained earnings, and ending cash.

💡 Hint

A fall in working capital is a source of cash, so subtracting a negative change adds it back.

Answer

Net income = 600-540 = $60; retained earnings = 150+60-15 = $195; CFO = 60+25-(-10) = $95; ending cash = 60+95-30-15 = $110.

Check your understanding

1. Net income for the period flows directly into which balance-sheet line?

Net income (less dividends) is added to retained earnings, the accumulated-profit component of equity.

2. Under the indirect method, cash flow from operations begins with:

The indirect method starts at net income and adjusts for non-cash charges and working-capital changes to reach operating cash flow.

✅ Key takeaways

Income statement measures profit; balance sheet is a snapshot with Assets = Liabilities + Equity; cash flow explains the change in cash.
Net income rolls into retained earnings and starts the cash flow statement.
Ending cash from the cash flow statement must equal the balance-sheet cash line.

➡️ Once the statements tie, analysts compress them into ratios. The next lesson starts with the ratios that ask whether a company can pay its bills: liquidity and leverage.

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