Explain the three hard linkages between the three financial statements.
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The answer
Net income sits as the last line of the income statement and becomes the first line of the cash from operations section on the cash flow statement. It also flows directly into the balance sheet: ending retained earnings always equals beginning retained earnings plus net income minus dividends. This turns a period measure into a snapshot balance, and that is the first hard linkage.
The second linkage is that the cash flow statement’s final output, beginning cash plus the net change across operating, investing, and financing activities, must exactly equal the cash balance on the period-end balance sheet. If those two numbers do not match, one of the statements is incomplete.
The third linkage is the one most candidates under-appreciate: every change in a non-cash balance sheet account has a corresponding line on the cash flow statement. An increase in accounts receivable is a use of cash in operations. An increase in PP&E beyond depreciation shows up as capital expenditures in investing. New debt raises financing inflows.
In fact, if you have the beginning and ending balance sheets and the income statement, you can derive the entire cash flow statement, because it is simply a re-sorting of those balance sheet deltas. This third linkage is what makes the statements a single integrated system.
Income statement
| Revenue | 1,000 |
| COGS | (600) |
| Gross profit | 400 |
| SG&A | (180) |
| EBITDA | 220 |
| D&A | (40) |
| EBIT | 180 |
| Interest expense | (20) |
| Pre-tax income | 160 |
| Taxes | (40) |
| Net income | 120 |
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- A company writes down $40 of impaired goodwill (non-tax-deductible, so there is no tax benefit from this specific write-down). Walk through the effect on all three statements, and explain why the tax treatment differs from a normal deductible expense.
- A company issues $150 of new equity for cash with no other changes. Walk through the effect on all three statements, and explain why this transaction, unlike a debt issuance, never creates a future income statement effect.
- A company recognizes $25 of bad debt expense by increasing its allowance for doubtful accounts (a contra-asset), with a 25% tax rate. Walk through the effect on all three statements at the time the allowance is recorded, and then when the specific receivable is later written off against that allowance (no further income statement or tax effect at write-off).
- At the start of the year, a company borrows $250 at 4% interest (interest paid annually, principal at maturity) and spends the full amount on equipment depreciated straight-line over 5 years with a full-year convention. Tax rate 25%. Trace the impact on net income, cash, and the balance sheet at the end of Year 1 and Year 2, and confirm the balance sheet balances both years.
- Midway through the fiscal year, a company issues $180 of debt at 5% annual interest and immediately uses the cash to repurchase $180 of its own stock. Tax rate 25%. Trace the full-year impact of both the interest expense (pro-rated for half a year) and the buyback on all three statements, and prove the balance sheet balances.
- A company receives a $60 cash prepayment for a service contract at the start of Year 1. It delivers half the service in Year 1 (no further cash changes hands) and the remaining half in Year 2 (also no further cash). Ignore taxes. Trace the effect on all three statements in Year 1 and Year 2, and confirm the balance sheet balances at the end of each year.
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The rest of this topic
The three statements, linked