How the three statements link

The three statements are three views of the same ledger. Once they are built, a handful of connections let you check that they agree, and those same connections let you forecast what any decision will do to profit, position and cash before you make it.

Four links to check every time

Net income flows to equity. The year's net income, less dividends, is the change in retained earnings. If the balance sheet's retained earnings does not equal opening retained earnings plus net income less dividends, something is missing.

The cash flow total equals the change in cash. Net cash from the three sections must equal the closing cash on the balance sheet less the opening cash.

Long-term assets roll forward. Opening cost plus purchases less disposals gives closing cost. Opening accumulated depreciation plus the year's depreciation expense (less amounts on disposals) gives closing accumulated depreciation. Purchases appear in investing cash flows; depreciation appears on the income statement and as an add-back.

Debt rolls forward. Opening loan plus new borrowing less repayments gives the closing loan. Borrowing and repayments appear in financing; interest appears on the income statement.

Working capital ties too, but it is already built into the indirect method: each change in a current asset or liability is the same number on the balance sheet comparison and on the cash flow statement.

Following one transaction through

Take a single entry and trace it. On December 31, Northside owed $4,000 of wages that staff had earned but would be paid in January.

On the income statement, wages expense includes the $4,000, reducing income before tax by that amount.

On the balance sheet, wages payable shows $4,000 as a current liability. Retained earnings is lower because net income is lower.

On the cash flow statement, the indirect method starts from the lower net income and adds back the $4,000 increase in wages payable. The net effect on 2025 operating cash is zero, which is correct: no cash moved.

Every transaction can be traced this way. If you trace it and one statement doesn't move as expected, you have found either an error or a misunderstanding, and both are worth finding before a lender or a tax authority does.

A change test

Analysts check a model by changing one input and confirming that all three statements respond coherently. Change Northside's depreciation to an eight-year life:

• Depreciation falls from $12,000 to $9,000.
• Income before tax rises by $3,000 to $35,680; tax at the case rate rises by $300; net income rises by $2,700.
• Net equipment rises by $3,000. On the other side, retained earnings rises by $2,700 and income tax payable by $300, so the balance sheet still balances.
• Operating cash flow is unchanged: net income is $2,700 higher, the depreciation add-back is $3,000 lower, and the tax payable add-back is $300 higher.

Cash does not care about useful life estimates. A model in which cash moves when you change depreciation has an error in it.

Building the linked model

A linked three-statement workbook keeps one set of inputs and derives everything else. The usual order is:

1. Inputs: revenue drivers, costs, capital spending, financing.
2. Income statement from the inputs.
3. Balance sheet, with retained earnings and debt rolled forward and working capital driven by the inputs.
4. Cash flow statement derived from the income statement and balance sheet changes.
5. Checks: balance sheet balances, cash flow equals change in cash, rollforwards agree.

The template for this lesson follows that order and carries a check row that should read zero in every column. A number typed over a formula is an easy error to make and a hard one to see, so the template keeps inputs on one sheet and colours them blue.