Three Financial Statements

What are the Three Financial Statements?

The 3 financial statements give a comprehensive portrayal of the company's operating activities.

These statements are informative tools that finance professionals can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.

Let’s take a brief look at the three statements below:

1. Income Statement (Profit and Loss Statement)

This statement shows a company's revenues and expenses over a specific period. It demonstrates whether a company is making a profit or incurring a loss during that time frame.

The income statement facilitates the analysis of a company’s growth prospects, cost structure, and profitability.

Analysts can use the income statement to identify the components and sources of net earnings.

2. Balance Sheet

This statement provides a snapshot of a company's financial position at a specific point in time. It consists of three main sections: assets, liabilities, and equity. The balance sheet follows the accounting equation:

Assets = Liabilities + Equity

This contrasts with the income statement, which reports a company’s revenues, expenses, and profitability over a specified period.

Most balance sheet items are reported at their historical cost; the balance sheet does not report the true market value of a company; only its resources and funding are reported at their historical cost.

3. Cash Flow Statement

This statement follows the inflow and outflow of cash within a business during a specific time. It is separated into three main areas: Cash Flow from Operating activities, Investing activities, and Financing activities.

The cash flow statement helps evaluate a company's ability to generate cash and handle its liquidity.

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The 3 Main financial statements are the Income Statement, Cash Flow Statement, and Balance Sheet.
Financial Statements are written records showing a snapshot of an entity's financial health. Regulatory agencies often audit these statements to ensure accuracy.
The 3 financial statements are a crucial part of finance professionals' day-to-day lives; they are used to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.

Overview of the Three Financial Statements

The balance sheet, income statement, and cash flow statement each offer unique details with information that is all interconnected. They provide various perspectives on a company's financial performance and position. Together, they offer a comprehensive view of a company's financial health.

Here's a quick overview of each statement and how they are interconnected:

Income Statement

When working on financial modeling or analysis of a company, the first place an investor or analyst will examine is the income statement.

The income statement reveals the performance of the business throughout each period, showing sales/revenue at the very top. Later, the cost of goods sold (COGS) is deducted to find gross profit.

Moreover, we will continue to adjust the gross profit, which is affected by other operating expenses and income, depending on the nature of the business.

Once all adjustments have been considered, we will get net income at the end of the statement — “the bottom line” for the business.

Income Statement Items

The Income Statement items can be divided into 2 categories:

1. Operating items

The most common Operating items of the income statement are as follows:

Revenue: Total value of goods and services credited to an income statement over a particular period.
Cost of Goods Sold (COGS): The cost of goods sold represents a company's direct cost to manufacture (for manufacturers) or procurement (for merchandisers) of a good or service that the company sells to generate revenue.
Selling, General & Administrative Expenses (SG&A): Operating costs not directly associated with the production or procurement of the product or service that the company sells to generate revenue. Payroll, wages, commissions, meal and travel expenses, stationary, advertising, and marketing expenses fall under this line item.
Research & Development (R&D): A company's activities directed at developing new products or procedures.
Other Operating Expenses /Income: Any operating expenses not allocated to COGS, SG&A, R&D, D&A
Depreciation & Amortization (D&A): The allocation of cost over a fixed asset's useful life to match the timing of the cost of the asset with when it is expected to generate revenue benefits.

2. Non-Operating items

Some of the most common Non-Operating items of the income statement are as follows:

Interest Expense: Interest expense is the amount the company has to pay on debt owed. This could be to bondholders or to banks.
Interest Income: A company’s income from its cash holdings and investments (stocks, bonds, and savings accounts).
Non-operating items: Items peripheral to core operations. It includes gains/losses on investments and revaluation of certain financial assets and debt obligations.
Tax Expense: The tax liability a company reports on the income statement.

The table below will show clearly how the income statement lines are impacted until they yield to the final Net Income line.

Income Statement Line
Income Statement Line	Formula
Gross Profit	Gross Profit = Revenue – Cost of Goods Sold
EBITDA	EBITDA = Gross Profit – SG&A – R&D – Other Operating Expenses
EBIT	EBIT = EBITDA – D&A
EBT	EBT = EBIT – Net Interest Expense – Other Non-operating items
NET Income	Net Income = EBT – Taxes

Balance Sheet

The balance sheet reports the company’s resources (assets) and how those resources were funded (liabilities and shareholders’ equity) on a particular date (end of the quarter, end of the year).

Assets

Assets represent the company’s resources. To qualify as an asset, the following requirements must be met:

A company must own/control the resource
The resource must be of value / economic benefit
The resource must have a quantifiable, measurable cost

Assets and Description
Asset	Description
Cash	Monies held by the company in its bank account or petty cash.
Marketable Securities / Short-Term Investments	Debt or equity securities held by the company.
Accounts Receivable (A/R)	Payment owed to a business by its customers for products and services already delivered to them.
Inventories	Any unfinished or finished goods that are waiting to be sold and the direct costs associated with the production of these goods.
Prepaid Expenses	When a company prepays for things like utilities, insurance, and rents, the right to future services becomes assets.
Property Plant and Equipment (PP&E)	Land, buildings, machinery, and equipment used to manufacture the company’s services and products.
Intangible Assets & Goodwill	Non-physical assets such as patents, trademarks, and goodwill acquired by the company that have value based on the rights belonging to that company.

Liabilities

Liabilities represent the claims against the company’s resources. To qualify as a liability, the following requirements must be met:

It is the result of a past transaction / probable that the present obligation will need to be settled
Resource of value / economic benefit will flow out of the entity
The resource must have a quantifiable, measurable cost

Liability and Description
Liability	Description
Accounts Payable	Obligations to pay suppliers for services and products already purchased from them but which have not been paid. In other words, accounts payable represent the company’s unpaid bills to its suppliers for services obtained on credit from them.
Accrued Expenses	Expenses like employee compensation that the company has incurred but for which it has not yet paid.
Deferred Revenue	Cash collected in advance from customers for products/services yet to be delivered, which will be recognized as real revenue over time.
Deferred Tax Liability	The company has paid lower taxes than what it owes, which will need to be made up for by paying additional taxes in the future.
Short term Debt	Debt due within 12 months
Long-Term Debt	Debt whose maturity exceeds 12 months

Equity

Equity represents sources of funds through equity investments and retained earnings (what the company has earned via its operations since inception).

Equity Description
EQUITY	Description
Preferred stock	Stock that has special rights and takes priority over common stock.
Common Stock	Represents capital received by a company when it issues shares.
Treasury Stock	Common stock that had been issued but then reacquired (repurchased) by a company.
Retained Earnings	Total company earnings/losses since its inception, less all dividends.

Cash Flow Statement

The cash flow statement then takes net income and modifies it for any non-cash expenses. Then, cash inflows and outflows are estimated using changes in the balance sheet.

The cash flow statement pictures the change in cash per period and the start and ending balance of cash. It is divided into three main sections: Cash Flow from Operating activities, Investing activities, and Financing activities.

Cash Flow from Operations

This area of the Cash Flow Statement provides insights into how well a business can produce cash from its regular business operations.

CFO is calculated by adjusting net income for non-cash items and changes in working capital. It starts with net income from the Income Statement and then adds back non-cash expenses (such as depreciation and amortization) and changes for differences in current assets and liabilities.

An optimistic CFO indicates the company is generating cash from its core operations. This is normally a positive sign, indicating the company's ability to finance its activities without relying on outer financing. Contrarily, a negative CFO may indicate that the company is using too much cash to sustain its operations.

Cash Flow from Operations is a vital metric for investors and analysts to evaluate a company's liquidity and ability to satisfy its short-term obligations.

Cash Flow from Investing Activities

This area of the Cash Flow Statement shows a deep comprehension of the cash generated or deployed by a corporation's investing activities during a specific period.

Investing activities involve purchasing and selling long-term assets such as property, plant, and equipment and investments in securities.

The CFI can be separated into a few sections:

Asset Purchases and Sales: This area contains cash transactions related to purchasing and disposing of long-term assets. For instance, when a company buys new equipment or sells an investment property, these transactions are recollected in the Cash Flow from Investing Activities.
Capital Expenditures: Cash spent on capital expenditures, such as purchasing property, plant, and equipment, is a significant component of Cash Flow from Investing. This indicates the company's investments in its infrastructure and long-term growth.
Investment in Securities: This section includes these transactions if a company buys or sells securities, such as stocks or bonds. For instance, purchasing shares in another company or selling marketable securities would affect Cash Flow from Investing.

The Cash Flow from Investing Activities provides information about a company's investment decisions and how it is deploying its capital for long-term growth and strategic initiatives.

Cash Flow from Financing Activities

Cash Flow from Financing Activities is a section in the Cash Flow Statement that records the cash transactions related to a company's financing activities during a specific period.

Financing activities involve transactions with the company's owners and creditors. Here are key points regarding Cash Flow from Financing:

Equity Transactions: Cash received from issuing stock or cash paid to repurchase stock is included in this section. When a company raises capital by issuing new shares, it generates positive cash flow. Conversely, repurchasing shares results in an outflow of cash.
Debt Transactions: Cash received from borrowing or issuing debt instruments (e.g., bonds) is recorded in this section. Repayment of debt involves an outflow of cash. Cash Flow from Financing reflects the issuance and repayment of loans, bonds, or other debt instruments.
Dividends: Cash payments made to shareholders in the form of dividends are included in this section. Payment of dividends represents a cash outflow, reducing the company's cash position.
Stock Buybacks: Cash spent on repurchasing the company's own stock is considered a financing activity. This is often done to return value to shareholders or adjust the company's capital structure.
Capital Structure Changes: Changes in the company's capital structure, such as the payment of dividends, issuing new debt, or repurchasing shares, have a direct impact on Cash Flow from Financing.

Cash Flow from Financing Activities captures the cash transactions associated with a company's financing decisions, including equity and debt-related activities.

It provides valuable information about how a company is managing its capital structure and returning value to its investors.

Once all the different cash flow statement sections have been reconciled, you can add them, and you will arrive at your final cash value that will flow into the balance as the first line item.

How are the three financial statements linked?

The three financial statements—Income Statement, Balance Sheet, and Cash Flow Statement—are interconnected and linked through accounting principles. Here's how they are related:

Net Income and Retained Earnings: The Net Income (or Net Loss) from the Income Statement directly affects the Equity section of the Balance Sheet. Net income increases equity, and a net loss decreases it. This change in equity is reflected in the Retained Earnings portion of the equity section on the Balance Sheet.
Balance Sheet Equation: The Balance Sheet follows the accounting equation: Assets = Liabilities + Equity. Any changes in assets, liabilities, or equity affect the balance of this equation. For example, if a company generates profits (as the Income Statement indicates), it increases equity on the Balance Sheet.
Cash Flow Impact: The Cash Flow Statement is connected to the Income Statement and the Balance Sheet. Net income from the Income Statement is used as the starting point for the Cash Flow from the Operating Activities section. Additionally, changes in certain Balance Sheet items, such as accounts receivable or accounts payable, are reflected in the Cash Flow Statement.
Investing and Financing Activities: The Cash Flow Statement details cash inflows and outflows related to investing and financing activities. These activities often have corresponding entries on the Balance Sheet. For example, the purchase or sale of assets (investing activities) affects the asset section of the Balance Sheet.

Changes in one financial statement have ripple effects on the others due to the interconnected nature of accounting. Analyzing all three statements together provides a comprehensive view of a company's financial health and performance.

How to Answer “How are the 3 financial statements linked together?”

If you face the question “How are the 3 financial statements linked together?” during your interview, remember to keep it short and sweet and only focus on some of the main points.

Sample Answer:

Once we subtract operating and non-operating expenses from Revenue, we will yield Net Income. Net Income from the Income statement floats to the balance sheet and cash flow statement.
On the cash Flow Statement, depreciation is added back, and Capital Expenditures are deducted from the cash flow statement, determining PP&E on the balance sheet.
Financing activities primarily influence the balance sheet and cash from finalizing, besides for interest, which is displayed on the income statement.
The aggregate of the prior period’s ending cash balance plus this period's cash from operations, investing, and financing is the closing cash balance on the balance sheet.

If the interviewer wants to ask for more details or ask about a specific item of the statements let him do so. The key here is to not be long-ended while answering the question.