Financial Analysis · Lesson 6
Connecting the
Three Statements
Big Idea
The three statements are one business told three ways:
- Income statement — is the business profitable?
- Balance sheet — is the business financially stable?
- Cash flow statement — is the business generating cash?
Good analysis asks a deceptively simple question: do the three stories agree with each other? When they diverge — profits up, cash down, debt rising — the divergence is the finding.
The Reconciliation Points
Three mechanical links tie the statements together. Anyone can check them — no accounting degree required:
| Link | What connects |
|---|---|
| Profit → cash | Net income is the starting point of operating cash flow; the adjustments between them explain the profit-cash gap. |
| Profit → equity | Net income rolls into retained earnings on the balance sheet (minus any dividends paid out). |
| Cash → cash | The cash flow statement’s ending balance must equal the cash on the balance sheet. |
These links matter most when someone hands you projections — a startup’s pitch model, an acquisition target’s forecast. Credible forecasts reconcile: projected profit rolls into projected equity, and the cash flow forecast ends at the projected cash balance. A model whose statements don’t tie together isn’t a forecast — it’s three unrelated spreadsheets.
When the Stories Disagree: Growth Eating Cash
Recall the pattern from Lesson 5: revenue up 50%, net income more than doubled, receivables more than quadrupled, cash down three-quarters. Each statement alone looks explainable. Read together, they describe a company whose growth consumes cash faster than it produces it — every new sale locks more money into receivables and inventory before a dollar is collected.
That is not automatically a reason to walk away. It is a reason to ask: who funds the gap while growth continues — the operating line? New equity that dilutes you? And what happens if the funding stops? The three statements together put that question on the table; any one of them alone hides it.
Interactive Checks
Check 1 of 3
A company earns net income of $80,000 and pays $30,000 in dividends during the year.
What happens to retained earnings on the balance sheet?
Check 2 of 3
A founder's five-year model shows the cash flow forecast ending Year 3 at $310,000, while the projected balance sheet shows Year 3 cash of $150,000.
What does this tell you?
Check 3 of 3
Profits are rising, cash is falling, and the company keeps drawing more on its credit line.
Which reading best reflects “the three stories together”?
Common Beginner Mistakes
- ❌ Reading statements in isolation. Each one can look fine alone while the combination tells a very different story.
- ❌ Accepting forecasts that don’t reconcile. If profit, equity, and cash don’t tie, the model is decoration.
- ❌ Treating a growing top line as safety. Growth is the classic cash consumer — check who is funding it.
- ❌ Missing dividends in the equity roll-forward. Retained earnings grow with profit and shrink with payouts.
Key Takeaways
- Three statements, one business — profitability, stability, cash
- Net income starts operating cash flow and rolls into retained earnings
- Ending cash must match the balance sheet — in history and in forecasts
- Divergence between the stories is the finding, not noise
- Growth that eats cash raises the question: who funds the gap?
Next Lesson
Trend Analysis — horizontal and vertical analysis: reading the direction of travel and spotting margins that deteriorate while sales grow.