The 3 financial statements are all linked and dependent on each other. In financial modeling What is Financial Modeling Financial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model. , your first job is to link all three statements together in Excel, so it’s critical to understand how they’re connected. This is also a common question for investment banking interviews, FP&A interviews, and equity research interviews. See Finance’s free interview guides Interviews Ace your next interview! Check out Finance's interview guides with the most common questions and best answers for any corporate finance job position. Interview questions and answer for finance, accounting, investment banking, equity research, commercial banking, FP&A, more! Free guides and practice to ace your interview to learn more.
In this tutorial, we will break it down for you step-by-step, although we assume you already have a basic understanding of accounting fundamentals and know how to read financial statements.
Want to see a live demonstration? Watch Finance’s free webinar on how to link the 3 financial statements in Excel Finance Webinar - Link the 3 Financial Statements This Finance quarterly webinar provides a live demonstration of how to link the 3 financial statements in Excel. Learn the formulas and proper linking procedure .
Accounting Principles
The income statement is not prepared on a cash basis – that means accounting principles such as revenue recognition, matching, and accruals can make the income statement very different from the cash flow statement of the business. If a company prepared its income statement entirely on a cash basis (i.e., no accounts receivable, nothing capitalized, etc.) it would have no balance sheet other than shareholders’ equity and cash.
It’s the creation of the balance sheet through accounting principles that leads to the rise of the cash flow statement.
Net Income & Retained Earnings
Net income Net Income Net Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through the income statement, the net profit is also used in both the balance sheet and the cash flow statement. from the bottom of the income statement links to the balance sheet and cash flow statement. On the balance sheet, it feeds into retained earnings and on the cash flow statement, it is the starting point for the cash from operations section.
PP&E, Depreciation, and Capex
Depreciation Depreciation Expense Depreciation expense is used to reduce the value of plant, property, and equipment to match its use, and wear and tear, over time. Depreciation expense is used to better reflect the expense and value of a long-term asset as it relates to the revenue it generates. and other capitalized expenses on the income statement need to be added back to net income to calculate the cash flow from operations. Depreciation flows out of the balance sheet from Property Plant and Equipment PP&E (Property, Plant and Equipment) PP&E (Property, Plant, and Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex, Depreciation, and Acquisitions/Dispositions of fixed assets. These assets play a key part in the financial planning and analysis of a company’s operations and future expenditures (PP&E) onto the income statement as an expense, and then gets added back in the cash flow statement.
For this section of linking the 3 financial statements, it’s important to build a separate depreciation schedule Depreciation Schedule A depreciation schedule is required in financial modeling to link the three financial statements (income, balance sheet, cash flow) in Excel .
Capital expenditures add to the PP&E account on the balance sheet and flow through cash from investing on the cash flow statement.
Working Capital
Modeling net working capital Net Working Capital Net Working Capital (NWC) is the difference between a company's current assets (net of cash) and current liabilities (net of debt) on its balance sheet. It is a measure of a company’s liquidity and its ability to meet short-term obligations as well as fund operations of the business. The ideal position is to can sometimes be confusing. Changes in current assets and current liabilities on the balance sheet are related to revenues and expenses on the income statement but need to be adjusted on the cash flow statement to reflect the actual amount of cash received or spent by the business. In order to do this, we create a separate section that calculates the changes in net working capital.
See a live demonstration of linking the three statements Finance Webinar - Link the 3 Financial Statements This Finance quarterly webinar provides a live demonstration of how to link the 3 financial statements in Excel. Learn the formulas and proper linking procedure to learn more.
Financing
This can be a tricky part of linking the three statements and requires some additional schedules. Financing events such as issuing debt affect all three statements in the following way: the interest expense appears on the income statement, the principal amount of debt owed sits on the balance sheet, and the change in the principal amount owed is reflected on the cash from financing section of the cash flow statement.
In this section, it’s often necessary to model a debt schedule Debt Schedule A debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows to build in the necessary detail that’s required.
Cash Balance
This is the final step in linking the 3 financial statements. Once all of the above items are linked up properly, the sum of cash from operations, cash from investing, and cash from financing are added to the prior period closing cash balance, and the result becomes the current period closing cash balance on the balance sheet.
This is the moment of truth when you discover whether or not your balance sheet balances!
How to Answer the Question in an Interview
If you get an interview question Interviews Ace your next interview! Check out Finance's interview guides with the most common questions and best answers for any corporate finance job position. Interview questions and answer for finance, accounting, investment banking, equity research, commercial banking, FP&A, more! Free guides and practice to ace your interview along the lines of, “How are the 3 financial statements linked together?” in an interview you shouldn’t go into as much detail as above, but instead simply hit the main points, which are:
- Net income from the income statement flows to the balance sheet and cash flow statement
- Depreciation is added back and CapEx is deducted on the cash flow statement, which determines PP&E on the balance sheet
- Financing activities mostly affect the balance sheet and cash from finalizing, except for interest, which is shown on the income statement
- The sum of the last period’s closing cash balance plus this periods cash from operations, investing, and financing is the closing cash balance on the balance sheet
If you want to see a video-based example, watch Finance’s webinar on linking the 3 statements Finance Webinar - Link the 3 Financial Statements This Finance quarterly webinar provides a live demonstration of how to link the 3 financial statements in Excel. Learn the formulas and proper linking procedure .
How to Link the Financial Statements for Financial Modeling
If you’re building a financial model in Excel it’s critical to be able to quickly link the three statements. In order to do this, there are a few basic steps to follow:
- Enter at least 3 years of historical financial information for the 3 financial statements
- Calculate the drivers/ratios of the business for the historical period
- Enter assumptions about what the drivers will be in the future
- Build and link the financial statements following the principles discussed above
The model essentially inverts, where the historical period is hardcodes for the statements and calculations for the drivers, and then the forecast is hardcodes for the drivers and calculations for the financial statements.
Check out Finance’s step-by-step courses to learn how to build financial models in Excel.
Video of Linking the 3 Statements
Watch Finance’s live video demonstration of linking the statements together in Excel.
More Financial Resources
We hope this has been a helpful guide on how the 3 financial statements are linked together. To keep learning more, please check out these relevant Finance resources:
- Free cash flow Cash Flow Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF
- EBITDA EBITDA EBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples
- Debt schedule Debt Schedule A debt schedule lays out all of the debt a business has in a schedule based on its maturity and interest rate. In financial modeling, interest expense flows
- Complete financial modeling guide Free Financial Modeling Guide This financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
- 3 statement model 3 Statement Model A 3 statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model. Examples, guide
- DCF model guide DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow
- Types of financial models Types of Financial Models The most common types of financial models include: 3 statement model, DCF model, M&A model, LBO model, budget model. Discover the top 10 types