How the 3 Statements Flow Together

At a high level, the flow of the 3 Statements is centered on the interaction between the Income Statement and the Balance Sheet.  The Cash Flow Statement can be considered a summary of how cash flows to/from the BS.

IS to BS Flows

It starts with the Income Statement.  Profits are generated as the difference between Sales to customers, less the costs needed to produce the Sales.  The profits are added to the BS as "Retained Earnings".  That means earnings/profits retained by the company.  Retained Earnings is on the BS as part of Equity.

Consider the following simple example of a company named PieCo.  PieCo makes apple pies.  PieCo sells one pie to a customer for $10 and the ingredients cost PieCo $7 for each pie it makes.  After the sale is complete, the IS reflects Sales of $10, expenses to make the pie (called Cost of Goods Sold) of $7 to yield a Gross Profit of $3.  It's called Gross Profit because not all the costs to produce the pie have been deducted.

In particular, PieCo must pay the rent and its employees.  These expenses are called overhead.  So the Gross Profit is not the final profit of operating PieCo.  To get the Operating Profit for a single pie, the overhead costs must be deducted from the Gross Profit.  Assuming that, on average for each pie, the rent and cost of employees totals $2, then PieCo's Operating Profit is $1. 

(How to arrive at the overhead cost per pie?  Take the overhead cost for the month -- a fixed monthly independent of the number of pies produced -- and divide it by the number of pies typically produced for the month.  For example, if the monthly rent and employee cost was $60 for the month and 30 pies were made, the overhead cost per pie would be $60/30 = $2 per pie.) 

Unfortunately, the government insists on collecting income taxes on income produced by a company.  Taxes are assumed to be $0 for this example.  However, if they were not zero, taxes would further reduce Operating Profit to yield Net Income.

Finally, for PieCo, with Operating Income of $1 less Taxes of $0, yields Net Income of $1.  The $1 of Net Income would be entered on the BS as Retained Earnings.  This is how the Net Income "flows" to the Balance Sheet.

BS Flows

As mentioned elsewhere (here), the BS is the scorecard for your company.  A number of items flow to and from the BS as your company operates.  The BS keeps track of them all.

At a high level, the $1 of profit earned by PieCo, would flow to Retained Earnings...which is part of Equity.  Also, the basic premise of a Balance Sheet is that it must balance.  Specifically:  Assets = Liabilities + Equity.

So, it follows, that at a high level, the $1 of Equity produced by the sale of a pie would, at a high level, result in an asset of $1.  What sort of asset?  Cash!  

In reality there's more going on.  In particular, Assets of $1 may NOT be in the form of cash, but in the form of a different asset.  What sort of asset?  Accounts Receivable!  

What is an Accounts Receivable?  Accounts Receivable (AR) is what is owed to your company by customers.  Because it is owed to your company, it is an asset.  The AR will  become cash when the customer pays, but until then, the $10 is an AR on the BS.  When the customer pays his invoice, the AR will be reduced by $10 and the cash account will be increased by $10.    

Returning to our pie example, when PieCo sold (and delivered) the pie to the customer, it could have accepted $10 in cash.  It didn't because the customer didn't have $10 at the time, so the customer accepted the pie and promised to pay PieCo next week.  Accordingly, PieCo gave the customer an invoice for $10 and accepted the customer's promise to pay it.  When PieCo produced the invoice, the AR was created.  Later, when the customer pays his bill, the AR will be reduced (by $10) and cash will be increased (by $10).

But wait you say:  An asset of $10 was received (as an AR which became cash), but the profit was $1...that doesn't balance!  Assets must equal Liabilities + Equity and $10 in AR doesn't equal the $1 added to Retained Earnings.  What's going on?  The answer is there are other flows to/from the BS to produce the pie.  Profit from the IS is only one such flow.

To produce the pie, PieCo needed ingredients.  Recall that those ingredients cost $7 and they were purchased using cash.  This is an outflow from the BS.  Also, to produce the pie employees and a rented building was needed.  These are additional outflows from the BS.  Recall, the overhead was $2.  So, the cash amount on the BS to produce the pie isn't $10, it's actually $1 = $10 - $7 - $2.  Because the amount of Equity on the BS is $1 (and we've assumed no other liabilities), the BS balances!

So, it's true, there's a lot going on "under the covers" in the cash flows of running a business.  That's the bad news.  The good news is that all Financial Forecasting Models from AFS are "prewired" to do these flows for you automatically. 

In fact, the IS/BS wiring generally does not change from business to business.  Only the factors which drive specific items are specific to a particular business.  For example, for PieCo, sales are driven by pies, but a different company,, may be selling Internet subscriptions.  Although the two businesses are very different, profits for flow to the BS the same as for PieCo.

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