Linking the Three Financial Statements into One Story

The “one story” model: one period, three views

The three statements are mechanically linked. The income statement explains profit for a period, the balance sheet explains positions at a point in time, and the cash flow statement explains cash movement over the period. The linkage work is a tracing exercise: start with revenue and expenses, compute net income, roll it into equity (retained earnings), reconcile net income to operating cash flow using non-cash items and working capital changes, then confirm the ending cash balance matches the balance sheet. Finally, use investing and financing sections to explain changes in long-term assets and debt/equity.

Guided tracing exercise (tight stepwise model)

Step 1 — Start with the period’s revenue and expenses (income statement)

Assume a simple company for Year 1 (Y1). We’ll keep taxes and interest out to focus on the mechanical links.

Key idea for linking: net income is an accrual-based result. It is not the same as cash generated. Depreciation reduced net income but did not use cash in Y1.

Step 2 — Net income flows into retained earnings (balance sheet equity)

Retained earnings is a cumulative account. The rollforward is:

Ending Retained Earnings = Beginning Retained Earnings + Net Income − Dividends

Assume beginning retained earnings were 300 and dividends were 40.

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This is the first “hard tie”: if the income statement says net income is 200, the retained earnings rollforward must reflect that same 200 (unless there are prior-period adjustments, which should be explicitly shown).

Step 3 — Reconcile net income to operating cash flow (cash flow statement, operating section)

Operating cash flow (CFO) typically starts with net income and adjusts for:

• Non-cash expenses (e.g., add back depreciation)
• Working capital changes (changes in current assets and current liabilities tied to operations)

Assume these working capital changes during Y1:

• Accounts receivable (AR) increased by 30 (customers owe more): use of cash
• Inventory increased by 20: use of cash
• Accounts payable (AP) increased by 10 (owed to suppliers): source of cash

Interpretation: the business reported 200 of profit, but generated 210 of operating cash because depreciation is non-cash (+50) and working capital changes net to −40.

Step 4 — Investing and financing explain long-term assets and capital structure changes

Now connect the remaining cash movements to long-term assets and to debt/equity.

Investing (CFI): Assume the company purchased equipment (capex) for 120 cash.

Financing (CFF): Assume the company borrowed 50 (new debt), repaid 30 of debt, issued 20 of new shares, and paid dividends of 40.

Step 5 — Confirm ending cash ties to the balance sheet

Assume beginning cash was 100. Then:

Ending Cash = Beginning Cash + Net Increase in Cash = 100 + 90 = 190

This ending cash must equal the cash line on the ending balance sheet.

Build the ending balance sheet from the traced movements

To see the “one story,” translate the period’s activity into ending balances.

Working capital positions (from the CFO adjustments)

• AR increased by 30
• Inventory increased by 20
• AP increased by 10

These changes show up as ending balance sheet differences versus beginning.

Long-term assets (capex and depreciation)

Equipment (PP&E) changes are explained by capex and depreciation (and possibly disposals). A simple rollforward:

Ending PP&E (net) = Beginning PP&E (net) + Capex − Depreciation

Assume beginning net PP&E was 400. Then ending net PP&E is 400 + 120 − 50 = 470.

Debt and equity (financing and net income)

Debt changes are explained by borrowings and repayments; equity changes are explained by share issuance and retained earnings (which itself is driven by net income and dividends).

Assume beginning debt was 200. Ending debt = 200 + 50 − 30 = 220.

Assume beginning common stock (or paid-in capital) was 500. Ending common stock = 500 + 20 = 520.

Retained earnings ending is 460 from the earlier rollforward.

Assemble a simplified balance sheet (ending)

Assume beginning balances for AR, inventory, and AP were: AR 70, inventory 80, AP 60. Apply the changes above to get ending balances: AR 100, inventory 100, AP 70. Cash ending is 190.

The balance sheet above is intentionally incomplete as a “teaching skeleton” (it’s missing other accounts), so totals won’t balance unless the starting balance sheet included only these accounts. In practice, you would include all accounts or treat the omitted items as “other assets/liabilities” so that the accounting equation holds. The key learning is the directional and mechanical links for each line item and the tie-outs described next.

Compact linkage table: where common line items appear across statements

Consistency checks and tie-outs (your audit trail)

1) Cash tie-out: ending cash on cash flow statement equals cash on balance sheet

• Compute ending cash: beginning cash + CFO + CFI + CFF
• Confirm it equals the cash line on the ending balance sheet

If it doesn’t match, the issue is usually: a missing cash flow line, a sign error, or a cash account classification mismatch (e.g., restricted cash treated differently).

2) Retained earnings rollforward tie-out

Ending RE = Beginning RE + Net Income − Dividends (± other equity adjustments)

• Net income must match the income statement exactly.
• Dividends must match financing cash outflows (if paid) and any declared-but-unpaid portion should appear as a liability (dividends payable).

Common failure mode: dividends recorded on the cash flow statement but not reflected in retained earnings (or vice versa).

3) Debt rollforward tie-out

Ending Debt = Beginning Debt + New Borrowings − Repayments (± non-cash items)

Non-cash items might include: amortization of debt issuance costs, discounts/premiums, foreign exchange remeasurement, or debt converted to equity. If your cash flow statement shows repayments/borrowings that don’t reconcile to the balance sheet change in debt, look for one of these non-cash movements or misclassification (e.g., a short-term portion moving between current and long-term debt).

4) PP&E rollforward tie-out (capex and depreciation)

Ending PP&E (gross) = Beginning PP&E (gross) + Capex − Disposals (at cost)

Ending Accum. Depreciation = Beginning Accum. Depreciation + Depreciation − Accum. Depreciation on disposals

If you only track net PP&E, ensure that capex (CFI) and depreciation (IS and CFO add-back) reconcile to the net change after considering disposals.

Mini-case: detect a mismatch and identify the likely error

Scenario

You are given the following summary for Y1:

• Net income (income statement): 200
• Depreciation (income statement): 50
• Working capital changes (from balance sheet): AR +30, inventory +20, AP +10
• Capex (cash flow investing): (120)
• Debt issued: +50; debt repaid: (30)
• Equity issued: +20; dividends paid: (40)
• Beginning cash (balance sheet): 100
• Ending cash (balance sheet): 170

Your tracing

First compute CFO from the provided items:

CFO = Net income + Depreciation − ΔAR − ΔInventory + ΔAP = 200 + 50 − 30 − 20 + 10 = 210

Then total cash change from the cash flow statement:

Net cash change = CFO + CFI + CFF = 210 − 120 + (50 − 30 + 20 − 40) = 210 − 120 + 0 = 90

Implied ending cash should be:

Implied ending cash = 100 + 90 = 190

But the balance sheet says ending cash is 170, a mismatch of 20.

Diagnose where the error likely sits

• Check financing first: the mismatch equals 20, which is exactly the equity issuance amount. A common classification error is recording share issuance on the balance sheet (paid-in capital increases) but forgetting to include the cash inflow in financing cash flow, or incorrectly netting it elsewhere.
• Alternative possibility: the equity issuance was non-cash (e.g., shares issued to acquire an asset or settle a liability). If so, it should increase equity on the balance sheet but not appear as a cash inflow; instead it should be disclosed as a non-cash investing/financing activity. In that case, the cash flow statement is correct to exclude it, and the “equity issued +20” line on the cash flow statement is the error.

Pinpoint with a tie-out question

Ask: “Did cash actually increase by 20 from issuing shares?” If bank records show no such deposit, then the cash flow statement classification is wrong (it included a non-cash equity issuance). If bank records show a deposit, then the balance sheet cash is wrong or the cash flow statement omitted the inflow.