The Three Financial Statements, Explained as One Story

The three financial statements aren't three separate documents. They're three views of the same year, and every number in one has a counterpart in another. This is Part 3 of our Read the Numbers series. We'll follow our hypothetical distributor from the balance sheet through the income statement and the cash flow statement, and show where each number lands.

The SEC's Beginners' Guide to Financial Statements warns that although it discusses each statement separately, "they are all related," and concludes that no one statement tells the complete story. Here's what that looks like in practice.

The one-sentence version

Start with two balance sheets

A balance sheet is a snapshot, so to see what happened during the year you need two of them: one at the start and one at the end. The changes between them are the story.

The end-of-year column is the balance sheet from our earlier article. The start-of-year column is the prior year's closing balance sheet for the same hypothetical company, built to be consistent with the other two statements. Notice that both columns balance: assets equal liabilities plus equity at both dates.

Following the profit

Here's the chain, step by step:

• Income statement: the company earned $96,000 of net income.
• Balance sheet (equity): that profit flows into equity, increasing what the owners have in the business. After paying out $20,000 in distributions, equity rises from $174,000 to $250,000.
• Cash flow statement: the same $96,000 is the first line of operating cash flow, which then adjusts for depreciation, receivables, inventory, and payables to arrive at $111,000 of cash.
• Balance sheet (cash): after equipment purchases and debt repayment, cash moves from $34,000 to $40,000.

A three-question read

When you pull up a real company's filing, you can run the same sequence in a few minutes:

• Is it profitable? Income statement: look at the three margins and whether they're stable or rising over several periods.
• Is the profit real cash? Cash flow statement: compare operating cash flow to net income, then subtract capital spending to see free cash flow.
• Can it survive a bad year? Balance sheet: look at the current ratio and debt-to-equity, and how much of the funding comes from borrowing.

A company that passes all three is usually a sturdier holding than one that only looks good on one. A company that looks good on the income statement but weak on cash flow deserves more questions before any money moves.

Don't skip the notes

The statements are only the headline. According to the SEC guide, the notes to the financial statements explain the accounting policies behind the numbers, along with details on items like income taxes, pensions, and stock options. The management's discussion and analysis (MD&A) section gives management's own view of results and requires disclosure of trends, events, or uncertainties likely to have a material impact. We cover where to find all of this in Part 4.

Common questions

How do the three financial statements connect?

Net income from the income statement flows into equity on the balance sheet and is the starting point of the cash flow statement. The cash flow statement's ending cash balance equals the cash line on the balance sheet. Changes in assets and liabilities between two balance sheet dates appear as adjustments in the cash flow statement.

Which financial statement is the most important?

None is sufficient alone. The income statement shows profitability, the cash flow statement shows whether profit turned into cash, and the balance sheet shows financial strength. Reading them together catches problems any single one can hide.

Why do I need two balance sheets?

A balance sheet is a snapshot at one date. Comparing the start and end of a period shows what changed, and those changes explain the cash flow statement.