How The 3 Financial Statements Of A Business Are Interdependent & Interconnected

The Three Statements:

1. The Income Statement
2. The Balance Sheet
3. The Statement of Cash Flows

1. Show a good net income- The net income is the starting point of the analysis. Also called the bottom-line of a company, it indicates profitability once all costs, expenses, depreciation, tax, interest etc are deducted. Although this is a good indicator, it does not end here.
2. Strong balance sheet- This is arguably the most important of the 3 financial statements to understand the health of a business. It is also known as score card or report card for a business. It gives a detailed report of the assets, liabilities & equity, and gives an estimate of the debt vs equity ratio (calculated by dividing a company’s total liabilities by its shareholder equity- ideal ratio is between 0.5-2 depending on the industry) and the working capital (the difference between current assets and current liabilities which needs to be positive).
3. Positive net cash flow- This means a business has made more cash than it has spent on its activities. The cash flow statement is divided into cash flow from operating activities, investing activities and financing activities. For a growing business the net cash flow from operating activities must be a positive value while the other two can be negative.

1. Making sales allows business to maintain cash balance. Any sales on credit generates accounts receivable and this means increase in accounts receivable in the cash flow statement which is debited.
2. Cost of goods sold- when a business buys products and are unused they are stored in inventory. The inventory is decreased or credited in cash flows when a product is used to make a sale, also called cost of goods expense in the income statement. If the products are bought on credit, it adds to accounts payable in the balance sheet and is noted as an increase or credit in the cash flow.
3. Depreciation & Amortization- Depreciation is recorded for fixed assets & amortisation for intangible assets such as patents. Depreciation does not reduce the fixed asset itself but is recorded in a different account as accumulated depreciation. The Capital expenditure accounts in cash flow statement maintains the credit for the purchase of the fixed assets (Property, plant and equipment).
4. Operating Expenses-These include broad range of expenses like selling, administration & other general expenses. They are distributed across prepaid expenses (when costs are prepaid before recording expense), Accounts payable (when purchases are made on credit), & accrued expenses payable (For all the unpaid expenses).
5. Interest Expense- Borrowing money from short term and long term notes causes the interest expense or income.
6. Income tax Expense- When income tax is unpaid at the year end, it is recorded under accrued expense liability.
7. Net Income- A positive net income increases retained earnings, which is also the starting point of a statement of cash flows. “Bottomline” of a statement is the net cash increases or decrease from the 3 types of activities in a cash flow statement, which is the increase in cash during year. When sufficient cash flow from profit is generated it can afford to pay cash dividends to share-owners.