Relationship Between Financial Statements

The four main financial statements are used to show different aspects of a business. It is important to understand the relationship between financial statements as this allows a full understanding of the financial performance of the business when analyzing financial statements

 

The Four Financial Statements

The 4 financial statements are as follows.

1. Balance Sheet – The balance sheet or statement of financial position, shows a financial snapshot of the assets, liabilities and equity of the business at a specific point in time.

2. Income Statement – The income statement shows the financial performance of the business over an accounting period in terms of its revenue, expenses, and net income.

3. Statement of Retained Earnings – The statement of retained earnings reconciles the beginning and ending retained earnings by adjusting for the net income and dividend distributions of the business.

4. Cash Flow Statement – The cash flow statement or statement of cash flows shows the cash inflow and cash outflow of the business over an accounting period.

Relationship Between Financial Statements

The relationship between financial statements can be seen by reviewing the basic trading operations of a business.

Opening Balance Sheet

All businesses start an accounting period with an opening balance sheet setting out the assets liabilities and equity at that point in time. In simplified form the opening balance sheet would be as follows.

Opening Balance Sheet at 1 January 2017
Cash 5,000
Accounts receivable 4,000
Inventory 3,000
Current assets 12,000
Long term assets 11,000
Total assets 23,000
Accounts payable 2,000
Other liabilities 2,500
Current liabilities 4,500
Long-term debt 7,000
Total liabilities 11,500
Capital 4,000
Retained earnings 7,500
Total equity 11,500
Total liabilities and equity 23,000

The opening balance sheet shows the assets, liabilities and equity at 1 January 2017. In this particular example, the opening cash balance is 5,000, and the opening retained earnings is 7,500.

Income Statement

During the accounting period the business trades and hopefully generates a net income. The income statement is used to show the revenue, expenses and net income of the business as follows.

Income Statement for the year ended 31 December 2017
Revenue 40,000
Cost of goods sold 18,000
Gross profit 22,000
Research and development 5,000
Sales and marketing 6,000
General and administrative 5,000
Operating expenses 16,000
Depreciation 2,300
Operating income 3,700
Finance costs 280
Income before tax 3,420
Income tax expense 684
Net income 2,736

After trading for a year, the net income of the business is 2,736 in the income statement shown above. The net income figure is now transferred to the statement of retained earnings.

Statement of Retained Earnings

The statement of retained earnings shows the income statement and balance sheet relationship.

The net income of the business is either distributed to investors by way of dividend or is retained within the business and increases its equity (equity = capital + retained earnings).

The statement of retained earnings is the financial statement used to reconcile the beginning and ending retained earnings.

Statement of Retained Earnings at 31 December 2017
Beginning retained earnings 7,500
Plus: Net income 2,736
Less: Dividends -300
Ending retained earnings 9,936

The statement of retained earnings above highlights the following relationship between financial statements.

The statement starts with the beginning retained earnings 7,500 from the opening balance sheet. It then includes the net income for the year 2,736 from the income statement, and deducts the amount of dividend (300) distributed to investors during the year.

The final line of the statement is the ending retained earnings 9,936 which is transferred to the closing balance sheet of the business, as shown below

Closing Balance Sheet

The closing balance sheet produced from the adjusted trial balance, shows the financial position of the business at the end of the year, in this case 31 December 2017.

In simplified form the closing balance sheet would be as follows.

Closing Balance Sheet at 31 December 2017
Cash 7,354
Accounts receivable 4,932
Inventory 4,438
Current assets 16,724
Long term assets 9,200
Total assets 25,924
Accounts payable 2,959
Other liabilities 2,789
Current liabilities 5,748
Long-term debt 6,240
Total liabilities 11,988
Capital 4,000
Retained earnings 9,936
Total equity 13,936
Total liabilities and equity 25,924

The closing balance sheet statement is produced from the adjusted trial balance, and highlights the following relationship between financial statements. The ending retained earnings 9,936 is linked to the last line of the statement of retained earnings.

The cash balance included in the closing balance sheet 7,354 should be that shown as the ending cash balance in the cash flow statement below.

Cash Flow Statement

The cash flow statement is produced from information contained in the ending balance sheet and the income statement and shows the cash inflows and outflows during the year.

Cash Flow Statement for the year ended 31 December 2017
Net income 2,736
Add back depreciation 2,300
Changes in working capital -1,122
Cash flow from operating activities 3,914
Amount paid for long term assets -500
Cash flow from investing activities -500
Repayment of long term debt -760
Dividend -300
Cash flow from financing activities -1,060
Net cash flow 2,354
Beginning cash balance 5,000
Ending cash balance 7,354

The cash flow statement shown above highlights the following relationship between financial statements.

The income statement and cash flow relationship is the net income. The cash flow statement starts with the net income 2,736 from the income statement, calculates the net cash flow for the year and adds this to the beginning cash balance 5,000 from the opening balance sheet.

The final line of the cash flow statement is the balance sheet and cash flow statement relationship. The ending cash balance 7,354 agrees to the cash balance in the closing balance sheet shown above.

Summary

The relationship between the four financial statements is summarized in the diagram below.

Relationship Between Financial Statements
Relationship Between Financial Statements

The numbers in red in the summary below refer to the stages referenced in the diagram.

The business starts with an opening balance sheet with a cash and retained earnings balance. The opening retained earnings balance is the starting position for the statement of retained earnings (1).

The business trades during the year generating a net income which is shown in the income statement and transferred to the statement of retained earnings (2). Part of the retained earnings is distributed to investors by way of dividend, and the ending balance is transferred to the closing balance sheet (3).

The cash balance from the opening balance sheet is the start of the cash flow statement (4).

The net income from the income statement forms the basis for calculating the cash flow from operating activities (5).

Information from the closing balance sheet is used to complete the cash flow statement and the cash balance in the closing balance sheet is agreed to the ending cash balance on the cash flow statement (6).

Last modified October 11th, 2018 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.

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