The three financial statements

Every company reports its finances in three statements. The income statement says how much the company earned over a period. The balance sheet says what it owns and owes at a moment. The cash flow statement says where its cash came from and where it went over the period. They are three views of one business, and a financial model is largely a machine for keeping them consistent.

The balance sheet

The balance sheet summarises the assets a company owns, what they are worth on its books, and the mix of debt and equity used to pay for them, all as of a point in time[1Source 1Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed. (Wiley, 2012), ch. 3, “The Basic Accounting Statements”.]. A textbook’s way of putting it: it is a snapshot of what a company owns and what it owes[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. It rests on one identity, assets equal liabilities plus owners’ equity, which holds for every transaction as well as for the whole statement[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. Assets and liabilities that come due within a year are listed as current[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]; the rest are long-term. Because it describes an instant, the balance sheet is dated: 31 December, say, not “the year”.

The income statement

The income statement covers a period, a quarter or a year, and lists the revenues earned in it, the expenses incurred to earn them, and the resulting income[1Source 1Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed. (Wiley, 2012), ch. 3, “The Basic Accounting Statements”.]. Where the balance sheet is a snapshot, the income statement is a video: it explains the change in one especially important balance sheet account, the owners’ equity, by splitting that change into revenues, which raise equity, and expenses, which lower it. The difference is net income, also called earnings[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. In a small worked example, a business with $900,000 of sales and $815,000 of wages, purchases, depreciation, other expenses, interest and tax earns $85,000, and that $85,000 is exactly the increase in its shareholders’ equity over the year[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.].

Two habits of the income statement matter for everything downstream. It is kept on the accrual principle, recording revenues and expenses when payment is reasonably certain, not when the cash is received or paid, and matching costs to the revenue they helped generate[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. And it records depreciation, which allocates the cost of long-lived assets bought in the past across the years they are used, so that costs are matched to the revenue they helped produce[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. Both are sensible, and both mean that income is not cash.

The cash flow statement

The cash flow statement is the second video. It sets out the sources and uses of cash over the period, grouped into operating, investing and financing activities, and it can be read as an explanation of why the cash balance changed[1Source 1Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd ed. (Wiley, 2012), ch. 3, “The Basic Accounting Statements”.]. Its concern is solvency: having enough cash in hand to pay the bills as they come due[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. In a model, its top line is net income from the income statement; the lines below it show the cash that went out, to buy equipment or repay debt, and the cash that came in from elsewhere, new borrowing, new shares or asset sales; and its bottom line is the total cash flow for the year, which can be negative in a year when the company spent more than it took in[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.].

The two links

The three statements are tied together by two rules, and a modelling textbook states them as exactly that[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.].

Rule one: net income adds to retained earnings. What the company earns is the owners’, so it joins the equity section of the balance sheet, in the account called retained earnings, on top of whatever retained earnings were already there from earlier years[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.].

Rule two: the cash at the end of the cash flow statement adds to cash on the balance sheet. The total cash flow for the year is added to last year’s cash to give this year’s cash, among the assets[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.].

A one-line example shows both. Suppose a company has revenues of $1,000 and no expenses at all. Net income is $1,000. The cash flow statement starts with that $1,000 and, with no other sources or uses, ends with a total cash flow of $1,000. On the balance sheet, cash on the left is $1,000, and retained earnings on the right is $1,000: it balances, and it balances because the two rules were followed, not because anyone forced it to[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.]. Add an expense of $100 and net income, retained earnings, total cash flow and cash all become $900; still balanced[3Source 3John S. Tjia, Building Financial Models, 3rd ed. (McGraw-Hill, 2018), §6.2.3, “The cash flow statement”; §6.4, the two rules; §6.5, “The basic flows among the three financial statements”.].

Line	No expenses	An expense of 100
Revenues	1,000	1,000
Expenses	0	(100)
Net income	1,000	900
Total cash flow	1,000	900
Cash (assets)	1,000	900
Retained earnings (equity)	1,000	900

Source: The illustration in the modelling textbook cited below, with its second case; no other lines exist in the example.

Where the links show up in a model

An M&A textbook describes the same circuit from the modeller’s side. Everything on the income statement from revenue down to tax feeds net income; net income flows to retained earnings on the balance sheet and appears as the first line of the cash flow statement; the cash flow statement runs through operating, investing and financing cash and finishes at the year-end cash balance, which is what the balance sheet shows at the top of its asset side[4Source 4Donald M. DePamphilis, Mergers, Acquisitions, and Other Restructuring Activities, 11th ed. (Academic Press, 2021), “Common Financial Model Linkages”.]. Companies keep a minimum cash balance for payroll and the like, and in a model any cash above that minimum may be used to repay debt; when it is, the year-end debt balance falls by the excess[4Source 4Donald M. DePamphilis, Mergers, Acquisitions, and Other Restructuring Activities, 11th ed. (Academic Press, 2021), “Common Financial Model Linkages”.]. That last step is the beginning of a debt schedule, and it is where a leveraged buyoutLeveraged buyoutA leveraged buyout buys a company mostly with borrowed money that the company then repays. How the debt, the sponsor’s equity and the exit fit together.Terms and methods · revised 28 September 2026 · 1,242 words · 4 sources · 6 min model’s arithmetic lives.

What the statements are not

The statements are an account of the past kept by rules, not a valuation. A finance textbook’s summary is blunt about the limits: many accounting values are based on past transactions and hence backward-looking, while market values look forward; accounting draws a line between realised and unrealised income that the economics does not; and accountants assign no cost to equity capital, so a positive accounting profit is not the same as financial health[2Source 2Robert C. Higgins, Analysis for Financial Management, 12th ed. (McGraw-Hill, 2018), ch. 1: the three statements, pp. 8–9, and the chapter summary, pp. 30–31.]. Valuation methods such as the discounted cash flowDiscounted cash flow analysisA discounted cash flow analysis values a business as the present value of the cash it should produce: the five steps, the discount rate and the terminal value.Terms and methods · revised 28 September 2026 · 1,128 words · 4 sources · 5 min start from these statements and then leave them, enterprise valueEnterprise value and equity valueEquity value is what the shares are worth; enterprise value is what the whole business is worth to all who fund it. How they link, and why cash is subtracted.Terms and methods · revised 28 September 2026 · 921 words · 4 sources · 5 min is built on top of the balance sheet rather than read off it, and measures like EBITDAEBITDAEBITDA is earnings before interest, taxes, depreciation and amortization: how it is calculated, why bankers compare firms with it, and why it is not cash flow.Terms and methods · revised 28 September 2026 · 1,060 words · 4 sources · 5 min are rearrangements of the income statement that the statements themselves do not report.

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  author       = {{xlsx.dev}},
  title        = {{The three financial statements}},
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