How do each of the Financial Statements relate to each other?

Understanding the three major financial statements, and how they are related, are essential to any company's success.

What are the three major financial statements?

The three financial statements that every company uses to make critical decisions are the income statement, the balance sheet and the cash flow statement. In order to understand how these three financial statements link together, it is important to first understand what each of these statements are individually. You can refer to “The Three Financial Statements” article on our website to gain a base understanding of the three financial statements. 

How are they linked to each other?

The three financial statements are all linked and dependent on each other. The income statement in it’s simplest form is revenues – expenses = net income. Revenues are generally a company's sales for its products and services, while expenses are mainly cost of sales and ensuing taxes. The net income represents a company’s profitability which flows into the balance sheet as retained earnings and into the cash flow statement as the beginning cash balance of a given period.

The balance sheet in it’s simplest form is assets = liabilities – shareholder’s equity. The balance sheet is a snapshot of a company’s financial position at any given point of time. The asset section begins with cash and cash equivalents, which comes directly from the ending cash balance found on the cash flow statement. Any balance sheet items that have a cash impact are linked to the cash flow statement. Net income from the income statement is also directly portrayed on the balance sheet as a change in retained earnings.

The cash flow statement is comprised of 3 main components. Cash flow from operating activities + cash flow from investing activities + cash flow from financing activities. It reflects a company’s financial activity over a period of time and shows where the company generates cash from and how that cash is being used in daily operations. Net income is the first line on the cash flow statement used to calculate cash flows from operations. Depreciation and amortization also comes from the income statement as any non-cash income or expense. The diagram below paints a great picture of just how the three financial statements are linked to each other.

What does all this mean?

Understanding these three financial statements and how they are linked can greatly benefit any company owner. Together, these three financial statements measures a company’s financial strength. In general, companies that are performing very well financially are consistently increasing their earnings and profit margins. This information is not only useful for the owner of a company, but in many cases is also useful for its investors. Investors of publicly traded companies look to these financial statements every quarter to judge their investment decision. If you are Club Capital client, you can utilize this as well to make your business more profitable.