The 3 Financial Statements: What Each Tells You and How They Link

Profitability is measured on an accrual basis, not a cash basis. A company can show profit while cash drains through working capital buildup (customers not paying), heavy capital expenditures, or debt repayments. The income statement records revenue when earned, but if customers pay on 90-day terms, that profit hasn't generated cash yet. This mismatch kills businesses.

First, net income from the income statement is the starting point for the cash flow statement. Second, the net change in cash from the cash flow statement equals the cash line on the balance sheet. Third, net income flows to retained earnings on the balance sheet through the retained earnings bridge: ending RE equals beginning RE plus net income minus dividends.

Work the statements in a fixed order: income statement, then cash flow statement, then balance sheet. Use the IS impact test at the start. If the item hits the income statement, calculate the pre-tax income change, apply the tax rate for net income, then carry it through CFO and into the balance sheet. If it does not (buying PP&E, issuing debt), say so and move to CFI or CFF, then the balance sheet. Building the balance sheet first forces a plug, because retained earnings needs net income and the cash line needs the net change in cash.

Usually not. Everything above the pre-tax income line flows straight down into it, so you can fast forward. Expenses up by 10 means pre-tax income down by 10. Revenue down by 10 means pre-tax income down by 10. SG&A up by 10 as an expense means pre-tax income down by 10. Anchor on pre-tax income, apply the tax rate, say net income, and move to the cash flow statement. Most of the time the interviewer is checking that you understand it, so reciting revenue, COGS, gross profit, OpEx, EBIT, and interest expense one at a time is beside the point. They can still ask you about any of those line items if they want to, so know where the item lands.

Say pre-tax income. Spoken out loud, EBT and EBIT are close to the same sound, and the interviewer can hear EBIT when you said EBT. That leaves you correcting them mid-answer. EBT is fine written down. In the room, use the full phrase and keep your language clear and simple.

Three come up in walkthrough questions. Walking the statements out of order, by opening on the balance sheet or at cash, which forces a plug: retained earnings needs net income and the cash line needs the net change in cash, so both are outputs of the other two statements. Recognizing deferred revenue immediately because the cash came in, when it sits as a liability and gets recognized ratably as the service is delivered. And answering in greater depth than the question called for, which buries the part the question actually asked for.

Think of them as one continuous statement in two parts. Part 1 (income statement) measures profitability on an accrual basis, showing where value was delivered and lost. Part 2 (cash flow statement) adjusts accrual profitability to show actual cash movements. Both feed the balance sheet: cash flows into the cash line and net income flows into retained earnings.