Understanding the relationship and links between the key financial statements is very important to business owners. This is because it will lead the organization to success. However, the financial statements are linked with each other. Therefore, they flow together to show the financial health of the company. Although, each financial statement can be prepared and presented to give a snapshot of particular financial information. They can’t be separate to understand the financial picture of the organization.
3 key financial statements
Statement of profit or loss, also called income statement reports whether an entity makes profit or loss during a period. So, it measures the financial performance of the business. This statement contains three core financial information such as revenue, expenses, profit, or loss for a period.
A balance sheet, also called a Statement of financial position. It shows the value of assets, liabilities, and equities at the end of a period. So, the balance sheet shows the net worth of the business. The net worth of an entity is the difference between total assets and liabilities. In the balance sheet, assets must equal equity plus liabilities (i.e. Assets = Equity + Liabilities).
Statement of cash flow
This statement contains the cash inflows and outflows of an entity. So, the cash flow statement reveals the movement of cash during a period, usually a year. It contains three sections. These sections are cash flow from operating activities, cash flow from investing activities as well as cash flow from financing activities.
The relationship and links between key financial statements
So, this article explains the relationships and links between the key financial statements such as income statements, balance sheets, and statements of cash flow. The relationship and link are explained as follows:
One of the relationships between the key financial statements is net income. The net income forms the bottom line statement of profit or loss. It is linked with the balance sheet by adding it to the retained earnings under equity in the balance sheet. Also, net income is the first line item under operating activities in the statement of cash flow. Therefore, the net income in the income statement is used to determine the closing equity in the balance sheet as well as determine the cash from the operation section in the cash flow statement.
Additionally, working capital is another relationship and link between the key financial statements. However, changes in the current assets and liabilities in the balance sheet are linked with revenue and expenses such as sales, purchases, and others in the income statement. More so, they have a link with changes in the movement of working capital calculated under operating activities in the cash flow. So, this is done to determine the actual amount of cash received or paid by the organization.
Property Plant and Equipment and Depreciation
The depreciation forms part of expenses to deduct in the income statement to arrive at net income. This depreciation is deducted from the value of Property Plant and Equipment (PP&E) in the balance sheet to arrive at the carrying amount. More so, it is added back in the statement of cash flow to determine cash flow from operation. Additionally, the Purchase of PP&E is added to the non-current assets in the balance sheet as well as deducted under investing activities in the cash flow. While sales of PP&E are deducted from the non-current assets in the balance sheet and added under investing activities in the cash flow. The depreciation on the assets purchased and profit/loss on assets disposal are adjusted in the income statement.
Another relationship and link between the key financial statements is the issue of the long-term loans to finance the business. The principal amount appears in the balance sheet as part of non-current liabilities and the statement of cash flow as part of financing activities. However, the interest on a loan is deducted from the income statement to arrive at net income.
Closing cash balance
The closing balance links the cash flow from operating activities, investing activities, financing activities as well as opening cash balance together.
In conclusion, all financial statements are interrelated and interconnected. So, the users must analyze all the financial statements together when analyzing the financial statements of an organization to determine the financial picture of the organization. Therefore, understanding the relationship and link will help a lot.
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.