Financial statements are the central elements of a firm’s accounting system, offering a detailed view of its performance. Each statement tells part of the story, but only when you connect them do they present a complete picture of the company’s monetary affairs. In this regard, you will require a thorough financial statement analysis to get the insights you need.
So, let’s examine how the three primary financial statements—the income statement, balance sheet, and cash flow statement—complement each other to offer insights into an entity's financial position.
Understanding Financial Statements Analysis: How 3 Financial Statements Are Interlinked?
The income statement, cash flow statement, and balance sheet are the three most important financial statements used to determine a business's financial health.
Public corporations must submit financial statements every quarter on Form 10-Q within a timeframe of 45 days after the end of each quarter. Annual financial statements, Form 10-K, must also be filed within 90 days of the end of the fiscal year. These interconnected financial reports are important for stakeholders and the general public to get a holistic overview of the organisation’s financial health.
Income Statement (Profit & Loss Statement)
The income statement reflects a company's revenues generated and costs incurred in a given timeframe, thus illustrating its profitability. It indicates whether the business is earning more than its outgoings or is at a loss.
Here is a formula to get the income statement:
Revenue - cost of goods sold = gross profit - operating expenses = operating income - interest expense = pre-tax income - income tax = net income (or loss)
Key Link: The net income figure at the end of each income statement is helpful for the equity quadrant of the balance sheet and, ultimately, a section for the cash flow statement.
Balance Sheet (Statement of Financial Position)
The balance sheet reflects a firm's current financial health at a particular time. It explains the current scenario of a company’s strongholds, i.e., assets, liabilities, and equity distributed amongst stakeholders.
Key Link: The net income from the income statement increases the equity section of the balance sheet, contributing to retained earnings.
Another Connection: The balance sheet contains the cash figure in the cash flow statement, and movements like accounts receivables and accounts payables are responsible for cash flows.
Cash Flow Statement
The cash flow statement explains the inflows and outflows of money caused by core business and additional cash-raising activities. It is important because it discloses the company's liquidity position and indicates whether the firm has enough cash to cover its obligations, which are due in the near future.
Key Link: The net income amount of the income statement is adjusted with the depreciation of noncash items and the movement of working capital items on the balance sheet to cash flow from operational activities.
Another Connection: The cash at the end of the cash flow statement is the cash asset and appears in the balance sheet.
Interconnected Financial Reports: A Brief Overview
The concept of accrual accounting connects these three financial statements. The former is the latter's base, starting with the connection between net income and cash flow.
- An increased net working capital (NWC) confirms more cash outflow, whereas a decreased NWC confirms the necessity of cash inflow.
- On the other hand, balance sheet and cash flow are connected in the following ways:
- Operating current asset increase → cash outflow
- Operating current asset decrease → cash inflow
- Operating current liability increase→ cash inflow
- Operating current liability decrease → cash outflow
- The statement of income links to the balance sheet using retained earnings, which are essentially the aggregate of all company earnings, less any dividends issued to shareholders.
Retained earnings are significant because they constitute one of the links between the three primary financial statements.
Case Study: Financial Statement Analysis
Any successful business must efficiently interconnect its financial statements to earn more profit. An example is Amazon. Founded in 1994, Amazon is one of the biggest global brands with multiple B2C services, primarily focusing on e-commerce.
Analysing its revenue data shows steady growth from 2012 to 2017, with a symmetrical interconnection between three primary financial statements. Amazon's proper arrangements for earning, cash flow, asset, and liability management are noteworthy for aspiring business owners.
To Conclude
When understanding financial statements analysis of a business, interlinking is necessary to understand the entire financial picture. If you want to seek a profession in this field, you can opt for the PGFAM Financial Accounting Course from Imarticus Learning.
Knowledge of such relationships enhances the quality of all managerial decisions and enables stakeholders to appraise the company's history, current standing, and development possibilities.
