What is the relationship between income statement balance sheet and cash flow?

What is the Relationship Between Financial Statements?

The financial statements are comprised of the income statement, balance sheet, and statement of cash flows. These three statements are interrelated in several ways, as noted in the following bullet points:

• The net income figure in the income statement is added to the retained earnings line item in the balance sheet, which alters the amount of equity listed on the balance sheet.

• The net income figure also appears as a line item in the cash flows from operating activities section of the statement of cash flows.

• Changes in various line items in the balance sheet roll forward into the cash flow line items listed on the statement of cash flows. For example, an increase in the outstanding amount of a loan appears in both the liabilities section of the balance sheet (as an ongoing balance) and in the cash flows from financing activities section of the statement of cash flows (in the amount of the incremental change).

• The ending cash balance in the balance sheet also appears in the statement of cash flows.

• The purchase, sale, or other disposition of assets appears on both the balance sheet (as an asset reduction) and the income statement (as a gain or loss, if any).

In short, the financial statements are highly interrelated. Consequently, when reviewing the financial statements of an organization, one should examine all of the financial statements in order to obtain a complete picture of its financial situation.

Balance Sheet vs. Cash Flow Statement: An Overview

The balance sheet and cash flow statement are two of the three financial statements that companies issue to report their financial performance. The financial statements are used by investors, market analysts, and creditors to evaluate a company's financial health and earnings potential. While the balance sheet shows what a company owns and owes, the cash flow statement records the cash activities for the period.

Key Takeaways

• A balance sheet shows what a company owns in the form of assets and what it owes in the form of liabilities.
• A balance sheet also shows the amount of money invested by shareholders listed under shareholders' equity.
• The cash flow statement shows the cash inflows and outflows for a company during a period.
• In other words, the balance sheet shows the assets and liabilities that result, in part, from the activities on the cash flow statement. 

Balance Sheet

A balance sheet lists a company's assets, liabilities, and shareholders' equity at a point in time, typically at the end of a period, such as the end of a quarter or year. A balance sheet shows what a company owns in the form of assets, what it owes in the form of liabilities, and the amount of money invested by shareholders listed under shareholders' equity (also referred to as owners' equity).

The balance sheet shows a company's assets, but also shows how those assets were financed, whether it was through debt or through issuing equity. The balance sheet is broken down into three parts: assets, liabilities, and owners' equity, and it is represented by the following equation:

Assets = Liabilities + Owners’ Equity where: Owners’ Equity = Total Assets minus total liabilities \begin{aligned} &\text{Assets} = \text{Liabilities} + \text{Owners' Equity} \\ &\textbf{where:} \\ &\text{Owners' Equity} = \text{Total Assets minus total liabilities} \\ \end{aligned} ​Assets=Liabilities+Owners’ Equitywhere:Owners’ Equity=Total Assets minus total liabilities​

To calculate the balance sheet, one would add total assets to the sum of total liabilities and shareholders' equity.

The balance sheet equation above must always be in balance. If cash is used to pay down a company's debt, for example, the debt liability account is reduced, and the cash asset account is reduced by the same amount, keeping the balance sheet even. The name "balance sheet" is derived from the way that the three major accounts eventually balance out and equal each other; all assets are listed in one section, and their sum must equal the sum of all liabilities and the shareholders' equity.

Below are examples of items listed on the balance sheet:

Assets 

• Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of deposit.
• Marketable securities are equity and debt securities.
• Accounts receivables are the amount of money owed to the company by its customers for product and service sales.
• Inventory is either finished goods or raw materials.

Liabilities 

• Debt including long-term debt
• Rent, taxes, utilities payable
• Wages payable
• Dividends payable

Shareholders' Equity

• Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity represents the net value or book value of a company. It is the amount of money that would be returned to shareholders if all of the assets were liquidated, and all of the company's debt was paid off.
• Retained earnings are recorded under shareholders' equity and are the amount of net earnings that were not paid to shareholders as dividends. Instead, the money was retained to be reinvested in the business, or pay down debt.

The balance sheet shows a snapshot of the assets and liabilities for the period, but it does not show the company's activity during the period, such as revenue, expenses, nor the amount of cash spent. The cash activities are instead, recorded on the cash flow statement.

Cash Flow Statement 

The cash flow statement shows the amount of cash and cash equivalents entering and leaving a company. 

The cash flow statement (CFS) measures how well a company manages and generates cash to pay its debt obligations and fund operating expenses. The cash flow statement is derived from the income statement by taking net income and deducting or adding the cash from the company's activities shown below.

The three sections of the cash flow statement are:

• Cash from operating activities
• Cash from investing activities
• Cash from financing activities

Operating Activities

Operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from the sale of a company's products or services.

Changes made in cash, accounts receivable, inventory, and accounts payable are shown in cash from operating activities and might include:

• Receipts from sales of goods and services
• Interest payments
• Income tax payments
• Payments made to suppliers
• Salaries and wages

Investing Activities

These activities include any incoming or outgoing cash from a company's long-term investments. Investing activities include:

• A purchase or sale of an asset
• Loans made to vendors or received from customers
• Merger or acquisition payments or credits to cash

Financing Activities

These activities include cash from investors or banks, as well as the use of cash to pay shareholders. Financing activities include: 

• Payment of dividends, which are periodic cash payments to shareholders
• Payments for stock repurchases, which reduces the number of outstanding shares
• Repayment of debt principal (loans)

A balance sheet is a summary of the financial balances of a company, while a cash flow statement shows how the changes in the balance sheet accounts–and income on the income statement–affect a company's cash position. In other words, a company's cash flow statement measures the flow of cash in and out of a business, while a company's balance sheet measures its assets, liabilities, and owners' equity.

Examples of How the Balance Sheet and Cash Flow Statement Differ

Below are copies of the balance sheet and cash flow statement for Apple Inc. (AAPL) as reported in the 10-Q filing on Dec. 28, 2019.

Balance Sheet

The balance sheet for Apple has the following entries listed for the quarter:

• Total assets were $340,618 (highlighted in green).
• Total liabilities were $251,087 (highlighted in red).
• Total equity was $89,531 (highlighted in gold).
• Total liabilities and equity were $340,618, (highlighted in blue), which equals the total assets for the period.

The balance sheet above shows a snapshot of Apple's assets and liabilities for the quarter, but you'll notice it does not show the amount of cash that was spent nor the profit or revenue generated for the quarter. 

Undoubtedly, Apple recorded cash flow activity as well as activity from the income statement, such as revenue and expenses. However, the balance sheet doesn't show the actual activity from the quarter. Instead, the balance sheet shows the results of what the company owns and owes as a result of that activity.

Cash Flow Statement

Apple recorded the following cash flow activities for the quarter:

• The cash flow statement starts with cash on hand and net income (in green at the top of the statement).
• After calculating cash inflows and outflows from operating activities, Apple posted $30,516 in cash from operating.
• Investing activities were -$13,668 billion (highlighted in red) in part due to purchases of marketable securities for $37,416 billion and purchases of plant and equipment for $2,107 billion.
• Financing activities was a -$25,407 (highlighted in gold) primarily as a result of share buybacks totaling $20,706 billion for the period.
• Apple had $41,665 billion in cash flow for the quarter (in green at the bottom of the statement).

To highlight the difference between the two statements, we can look at Apple's investing activities, which included approximately $2.1 billion dollars in purchases of property, plant, and equipment. On Apple's balance sheet (shown earlier), the company recorded $37 billion dollars in property, plant, and equipment. That total includes the $2.1 billion purchase for those fixed assets, which was recorded as a cash outflow in investing activities.

An extreme example would be if Apple decided to pay off $70 billion of its term debt, which totals approximately $93 billion listed on the balance sheet. The company would record the cash outlay of $70 billion dollars within the financing activities section of the cash flow statement. Also, the term debt total on the balance sheet would be listed as the reduced amount of $23 billion.

While the cash flow statement shows cash coming in and going out, the balance sheet shows the assets and liabilities that result, in part, from the activities on the cash flow statement. 

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What is the relationship of financial statements with each other?