How the Financials Connect?
Did you know that the financial statements are all connected?
Understanding how this connection works has been one of the most impactful things in my career…
Let’s do a deep dive on how it all connects
An overview of the financial statements
Let’s start with a recap on the 3 financial statements, and what they each do.
You may also hear about the Statement of changes in Equity, and the Notes to the financial statements when you hear the term “Financial Statements”…
but most commonly, when you hear this term, it will refer to these 3 financial statements:
The Profit & Loss This statement tells you what you are generating in income, vs what you are incurring in expenses. You can also see multiple levels of profitability
The Balance Sheet This statement shows you the net worth of your company.
The Statement of Cash Flows This statement shows you how you cash is moving from one period to the next.
Here’s a quick summary on how these all work:
The Profit & Loss
Let’s start with the Profit & Loss
As we spoke about, the Profit & Loss tells you about your profits, and your expenses
It showcases the profitability of your sales & expenses at 4 different levels, with the ultimate level being your Net Income
The Profit & Loss is the only statement that doesn’t pull from any other other statements, however it’s possible that you’ll have journal entries that are affected by your Balance Sheet
The Profit & Loss pushes your Net Income to both your Balance Sheet via your Retained Earnings, and Statement of Cash Flows via your Cash from Operating Activities
The Balance Sheet tells you about the net worth of your business
it is separated by Assets, Liabilities, and Owners equity
The Balance Sheet PULLS from the Profit & Loss via Retained Earnings, and also overlaps with the Profit & Loss via a number of journal entries
The Balance Sheet also PUSHES information to the Statement of Cash Flows for all accounts, except for Cash, Accumulated Depreciation & Accumulated Amortization, and Retained earnings
instead, these values are pulled from the P&L (except for cash ofcourse)
The Statement of Cash Flows tells you about the movements in your cash
It is presented on both the Direct Method, and the Indirect Method, with the Indirect method being the most popular given it’s ease of preparation
The indirect method doesn’t tell you any new information - all of the information can be found directly from your Profit & Loss, and your Balance Sheet
The Statement of Cash Flows PULLS from your Profit & Loss via your Net Income, Depreciation, and Amortization, which goes into Cash from Operating activities
It PULLS from the changes in your balance sheet items from one period to another, where it takes your last months balance for your Assets, and subtracts this months balance
For Liabilities & Owners Equity, it takes this months balance, minus last months balance
The Cash from Operating Activities section PULLS from the Balance Sheet via the change in your current assets and your current liabilities
The Cash from Investing Activities section PULLS from the Balance Sheet via the change in your fixed, intangible, & long term assets
Finally, the Cash from Financing Activities section pulls from your long term liabilities and owners equity
As you can see, the Statement of Cash Flows has the largest amount of connections to the other financial statements…
in fact, it doesn’t even provide you with new data, if you’re using the indirect method.