Lesson 1 of 10
The three statements and how they join
The income statement, the balance sheet and the cash flow statement answer three different questions, and three arithmetic joins hold them to each other.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The income statement covers a period, the balance sheet covers one day, and the cash flow statement covers that same period again, in cash.
- Three arithmetic joins tie the statements to each other, and net income landing in retained earnings is one of them.
- The stronger rule, that profit explains every change in equity, fails by design: other comprehensive income moves equity without passing through that year's net income.
The income statement asks whether revenue covered its costs, the balance sheet what the company owns and owes on one day, and the cash flow statement where the cash went. Three arithmetic joins tie them together. A stronger rule most readers assume, that profit explains every change in equity, fails by design.
How profit reaches the balance sheet
- 1Income statementNet income for the period
- 2Retained earningsPlus profit, less dividends
- 3Balance sheetClosing equity
How cash reaches the balance sheet
- 1Cash flow statementStarts from net income, ends at the change in cash
- 2Balance sheetClosing cash
The joins that hold
Profit lands in equity: net income at the foot of the income statement is added to retained earnings, less any dividend declared. The cash flow statement's net change in cash, added to opening cash, equals the cash on the balance sheet, restricted cash included; a note reconciles the two when they sit on different lines. And the cash flow statement itself starts from net income and works towards cash, because profit and cash disagree about timing: depreciation took no cash this year, and a sale on credit brought in none yet.
Where the joins stop
The profit-into-equity join is a special case of the clean surplus relation: closing equity should equal opening equity plus net income less net distributions to owners (dividends and buybacks, less new shares issued). It fails whenever other comprehensive income exists. Foreign currency translation of a subsidiary, pension remeasurement, and the effective portion of some hedges move equity directly, bypassing net income in the year they happen.
Stephen Penman's case for reformulating the statements is that the published presentation mixes operating activities with financing, so an analyst separates the two before measuring operating profitability.
Two figures easy to confuse with cash
Retained earnings is not cash. It is the running total of profit never paid out, and by the time you read it that money is usually spent on inventory or equipment. Free cash flow is not a filed line at all. It is operating cash flow less capital expenditure, computed by the reader from two lines the cash flow statement does report, which is why two publishers routinely disagree on the same company and year.
Where this reading stops working
A bank's balance sheet is not split into current and non-current, and its deposits are operating liabilities rather than borrowings. An insurer's largest liability is an actuary's estimate rather than an amount owed on a date. Later lessons in this course say where each reading breaks for these filers.
Check yourself
The cash flow statement covers the same period as which other statement?
- The balance sheet
- The income statement
- Neither, it covers one day
Show the answer
Answer: B.
The balance sheet is the one statement for a single day. The income statement and the cash flow statement both cover the same span of time.Net income was 100, the dividend was 40, and no shares were issued or bought back. Total equity still fell by 90. What explains it?
- The filing contains an arithmetic error
- A loss recorded in other comprehensive income
- The dividend was larger than reported
Show the answer
Answer: B.
Profit less the dividend adds 60, so 150 left equity without passing through that year's net income: a currency translation loss or a pension remeasurement.Which statement tells you whether reported profit arrived as cash?
- The balance sheet
- The cash flow statement
- The statement of shareholders equity
Show the answer
Answer: B.
The cash flow statement reconciles net income to operating cash flow one adjustment at a time, which is the direct comparison between profit and cash.Sources
- Penman, Financial Statement Analysis and Security Valuation, on reformulated financial statements and residual earnings.
What this leaves out
- Companies reporting under international standards present the same three joins under different line names, and the joins still hold.
- Which items route through other comprehensive income varies by company and is disclosed in the equity note, not summarised here.
- Banks, insurers and real estate investment trusts present balance sheets that are not split into current and non-current. Later lessons say where that changes the reading.
- The worked example uses round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.