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Module 6 · Linking the three statements Advanced

The statements are one connected system. The main links:

RS 201 Financial Statement Analysis · By · ~6 min read, ~2 hr with practice · Not started
Watch first 4:16 · video lesson

Pause and write. When something clicks, pause and put it in your own words in My notes.

By the end of this module you'll be able to

  • Trace any transaction through all three statements and keep the balance sheet in balance.

Overview

Worked example 1: depreciation rises by $10

This is the classic investment banking interview question. Assume a 25% tax rate.

  1. Income statement: pre-tax income falls by 10; tax falls by 2.5; net income falls by 7.5.
  2. Cash flow statement: net income is down 7.5, depreciation add-back is up 10, so CFO and cash rise by 2.5.
  3. Balance sheet: cash up 2.5, PP&E down 10, so assets fall by 7.5. Retained earnings fall by 7.5. Both sides fall by 7.5 and the sheet balances.

The insight: depreciation is non-cash, but it saves tax, so more depreciation means more cash.

Worked example 2: buying $100 of inventory with cash, then selling it for $150

Tax rate 25%.

  • On purchase: no income statement effect. Cash down 100, inventory up 100. CFO down 100.
  • On sale for cash: revenue 150, COGS 100, pre-tax profit 50, tax 12.5, net income 37.5. Inventory down 100, cash up 150 minus 12.5 tax = 137.5.
  • Net over both steps: cash up 37.5, retained earnings up 37.5.
Worked example 3: issuing $200 of debt to buy equipment

No income statement effect on day one. CFF +200, CFI -200, cash unchanged. PP&E +200, debt +200. In later years interest expense and depreciation reduce net income.

The balancing test

In any exercise, finish by checking that assets still equal liabilities plus equity. If they do not, a link is missing.

Working through more transactions

The method is always the same: income statement first, then the cash flow statement, then the balance sheet, then check that it balances. Assume a 25% tax rate and that tax is paid in cash unless stated.

Worked example 4: an inventory write-down of 40
  1. Income statement: pre-tax income falls 40; tax falls 10; net income falls 30.
  2. Cash flow statement: net income down 30; the write-down is non-cash and is added back, +40; cash rises 10, the tax saving.
  3. Balance sheet: cash +10, inventory -40, so assets fall 30; retained earnings fall 30. It balances.
Worked example 5: a bonus of 15 is accrued but not yet paid
  1. Income statement: expense +15; pre-tax income -15; tax -3.75; net income -11.25.
  2. Cash flow statement: net income -11.25; the increase in accrued liabilities is a source of cash, +15; cash rises 3.75.
  3. Balance sheet: cash +3.75; accrued liabilities +15 and retained earnings -11.25, so liabilities and equity rise 3.75. It balances.

When the bonus is paid next year, cash falls 15 and accrued liabilities fall 15, with no effect on that year's income statement.

Worked example 6: issuing shares and paying a dividend

Issuing 100 of new shares for cash: no income statement effect; financing cash flow +100; cash +100 and share capital +100. Paying a dividend of 20: no income statement effect; financing cash flow -20; cash -20 and retained earnings -20. Dividends are a distribution of profit, not an expense.

Worked example 7: a customer prepays 60 for next year’s service

No income statement effect this year. Operating cash flow +60 through the increase in deferred revenue. Cash +60 and deferred revenue +60. Next year, revenue of 60 is recognized with no cash coming in, and deferred revenue falls back to zero.

A quick checklist for any transaction

Question If yes
Does it change revenue or an expense this period? It hits the income statement, then tax, then net income
Is any part of the expense non-cash? Add it back in operating cash flow
Does it change an operating asset or liability? It is a working capital line in operating cash flow
Is it buying or selling a long-term asset? Investing cash flow
Is it borrowing, repaying, issuing, buying back or paying dividends? Financing cash flow

Why this matters to an investor

Most accounting surprises are one of these patterns in disguise: a write-down, an accrual reversal, a reclassification. Being able to trace them through all three statements is how you tell a cash event from a paper one.

Put it into practice

Your mission

In a spreadsheet, enter Maple's base-year statements. Then apply each event and rebuild all three statements: (1) SG&A rises by 20; (2) the company repurchases 30 of shares with cash; (3) a customer pays 40 of receivables. Confirm the balance sheet balances after each.

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Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.