Connecting the Three Statements#

The three financial statements aren't independent documents—they're interconnected parts of a unified financial picture. Understanding these connections helps you verify data, spot problems, and build a complete understanding of any company.

The Core Connections#

1. Net Income Links All Three#

Net income is the central connection point:

INCOME STATEMENT → BALANCE SHEET
     Net Income → Added to Retained Earnings

INCOME STATEMENT → CASH FLOW STATEMENT
     Net Income → Starting point for Operating Cash Flow

If a company reports $100M in net income:

• Retained earnings on the balance sheet should increase by $100M (minus any dividends)
• The cash flow statement should start with $100M (before adjustments)

2. Ending Cash Must Match#

The cash flow statement's ending balance must equal the balance sheet's cash:

CASH FLOW STATEMENT → BALANCE SHEET
     Ending Cash = Cash on Balance Sheet

This is an absolute tie-out. If they don't match, something is wrong.

3. Balance Sheet Changes Explain Cash Flow#

Every major change on the balance sheet has a corresponding cash flow impact:

Tracing a Transaction Through All Three#

Let's follow a sale through all three statements:

Scenario: Company sells $1,000 of product on credit#

Income Statement:

• Revenue: +$1,000
• COGS: -$600 (assume)
• Net Income: +$400 (after other expenses/taxes)

Balance Sheet:

• Inventory: -$600 (sold)
• Accounts Receivable: +$1,000 (not yet collected)
• Retained Earnings: +$400 (from net income)

Cash Flow Statement:

• Net Income: +$400
• Decrease in Inventory: +$600
• Increase in Receivables: -$1,000
• Net Operating Cash Flow: +$0

Scenario: Customer pays the $1,000#

Income Statement:

• No impact (revenue already recognized)

Balance Sheet:

• Cash: +$1,000
• Accounts Receivable: -$1,000

Cash Flow Statement:

• Decrease in Receivables: +$1,000
• Net Operating Cash Flow: +$1,000

Now the cash arrives—and it shows up on both the balance sheet and cash flow statement, but NOT the income statement.

Using Connections for Verification#

Retained Earnings Reconciliation#

Check that retained earnings change makes sense:

Ending RE = Beginning RE + Net Income - Dividends

If this doesn't tie out, investigate. Common causes:

• Stock-based compensation adjustments
• Prior period adjustments
• Comprehensive income items

Cash Reconciliation#

Verify the cash flow statement:

Ending Cash = Beginning Cash + Operating CF + Investing CF + Financing CF

This should exactly match the cash on the balance sheet.

Debt Reconciliation#

Check that debt changes in financing activities match balance sheet changes:

Spotting Inconsistencies#

The connections help you identify problems:

Warning Sign: Numbers Don't Tie#

If the basic reconciliations don't work:

• Could be an error in the filing
• Could indicate manipulation
• At minimum, requires investigation

Warning Sign: Unusual Divergence#

When metrics that usually move together diverge:

Building the Holistic View#

The Complete Analysis Flow#

1. Start with the Income Statement

   • Is the company profitable?
   • What are the margin trends?

2. Check the Balance Sheet

   • Is the company stable?
   • What are the asset and liability trends?
   • Does retained earnings growth match net income?

3. Verify with Cash Flow

   • Is cash flow confirming profits?
   • Where is cash going?
   • Does ending cash match the balance sheet?

Questions the Connection Answers#

Practical Example: Company Analysis#

Company XYZ Analysis#

Income Statement:

• Revenue: $500M (up 20%)
• Net Income: $50M (up 25%)
• Looks great!

Balance Sheet Check:

• Receivables: Up 50% (red flag—growing faster than revenue)
• Debt: Up 40% (funding growth with debt?)
• Retained Earnings: Up $30M (where did the other $20M of income go?)

Cash Flow Verification:

• Operating CF: $20M (much less than $50M net income!)
• Investing CF: -$60M (heavy investment)
• Financing CF: +$50M (borrowed to fund investments)

Conclusion: The income statement looks good, but the connections reveal concerns:

• Earnings quality is poor (cash flow << net income)
• Receivables growth suggests collection issues
• Heavy reliance on debt financing