The 3 Accounting Statements and How They Connect

Financial statements are formal records of a company’s financial activities that provide a structured overview of its performance and position. For investors and managers, these reports are a primary source of information for understanding a company’s financial health. There are three main financial statements that, when viewed together, offer a comprehensive picture of a company’s financial standing. Each statement provides a different perspective, and understanding how they connect tells a complete financial story.

The Balance Sheet

The Balance Sheet presents a snapshot of a company’s financial position at a single moment in time. It is governed by the accounting equation: Assets = Liabilities + Equity. This equation must always be in balance, meaning a company’s resources must equal the claims against those resources by creditors and owners.

Assets are economic resources owned by the company with future economic value. Current assets, like cash and cash equivalents, are expected to be converted into cash within one year. Accounts receivable represents money owed to the company by its customers for goods or services already delivered. Inventory includes raw materials, work-in-progress, and finished goods. Non-current assets, such as property, plant, and equipment (PP&E), are long-term resources not expected to be converted to cash in the short term.

Liabilities are a company’s financial obligations or debts. Current liabilities are debts due within one year, such as accounts payable (money owed to suppliers), short-term loans, and accrued expenses. Long-term liabilities are obligations due more than one year from the balance sheet’s date, such as long-term bank loans or bonds payable.

Equity, or shareholders’ equity, represents the residual interest in the assets after deducting liabilities. Its main components are common stock and retained earnings. Common stock is the capital received from investors, while retained earnings are the cumulative net income minus any dividends paid. For example, if a bakery has $50,000 in assets and $20,000 in liabilities, its equity would be $30,000.

The Income Statement

The Income Statement, or Profit and Loss (P&L) statement, reports a company’s financial performance over a specific period, like a month or year. It shows profitability by summarizing revenues and expenses. Unlike the Balance Sheet’s snapshot, the Income Statement shows financial activity over time, culminating in the “bottom line”: net income.

The statement begins with the “top line,” which is revenue or sales, representing the total money generated from selling goods or services. A principle of accrual accounting is that revenue should be recorded when it is earned, regardless of when cash is received.

From revenue, the Cost of Goods Sold (COGS) is subtracted to find the Gross Profit. COGS includes the direct costs of producing goods, such as raw materials and direct labor. Gross profit measures how efficiently a company manages its production.

After gross profit, operating expenses are deducted. These are costs from normal business operations not directly tied to production, such as salaries, rent, and marketing costs. Depreciation expense, a non-cash charge that allocates an asset’s cost over its useful life, is also included. Subtracting all expenses, including interest and taxes, from revenue results in Net Income.

The Statement of Cash Flows

The Statement of Cash Flows summarizes cash inflows and outflows over a specific period. It reconciles net income from the Income Statement, which is based on accrual accounting, with the company’s actual cash position. The statement shows how a company generates and uses cash and is broken down into three activities.

The first section, Cash from Operating Activities, reports cash generated by a company’s main revenue-producing activities. It adjusts for non-cash items like depreciation and changes in working capital accounts, such as accounts receivable and accounts payable. This shows the true cash impact of operations.

Cash from Investing Activities shows cash used for or generated from acquiring and disposing of long-term assets. This includes the purchase or sale of property, plant, and equipment (PP&E), known as capital expenditures (CapEx). It also includes cash flows from buying or selling other businesses or securities, indicating how a company invests in its future.

Cash from Financing Activities includes cash flows between a company, its owners, and its creditors. Examples include cash from issuing stock or borrowing money. It also includes cash outflows for repaying debt, paying dividends, or repurchasing stock. The sum of the cash flows from all three activities equals the net change in cash for the period.

How the Three Statements Connect

The three financial statements are intricately linked, and understanding their connections is necessary for a complete financial analysis. The process reveals how a company’s operational performance and financing decisions affect its overall financial position.

The connection begins with the Income Statement’s net income. A portion of net income may be paid as dividends, while the remainder is added to the retained earnings on the Balance Sheet. This directly impacts the shareholders’ equity section.

Net income is also the starting point for the Statement of Cash Flows. In the operating activities section, net income is adjusted for non-cash expenses and changes in working capital. This calculates the net cash from core business operations and reconciles reported profit with actual cash flow.

The Statement of Cash Flows calculates the ending cash balance for the period. This ending cash balance must precisely match the cash and cash equivalents figure reported on the Balance Sheet. This final link ensures the integrity of the accounting system, confirming that the changes in cash are accurately reflected in the company’s financial position.