5.4: Relationship with Other Financial Statements

The cash flow statement is intrinsically linked to the income statement and the balance sheet. Together, these three financial statements offer a complete view of a company’s financial performance and position.

The income statement records revenues and expenses and calculates net income over a period. This net income becomes the starting point in the cash flow statement under “cash flows from operating activities” (when using the indirect method). However, net income includes non-cash elements like depreciation and excludes changes in working capital, which are addressed in the cash flow statement.

The balance sheet presents the company’s assets, liabilities, and equity at a specific date. The changes in these items between the two balance sheet dates help explain the cash movements recorded in the cash flow statement.

For example, consider inventory: if it increases during a period, the company purchases more goods than it sells. Although this purchase reduces cash, it doesn't appear on the income statement as an expense until the inventory is sold. This means that the cash flow statement subtracts the increase in inventory from net income to reflect the cash outflow.

Similarly, investing and financing activities—such as purchasing equipment or issuing debt—impact the balance sheet and appear in the cash flow statement.

In essence, the cash flow statement serves as a reconciliation tool, connecting the income statement’s profit with actual changes in cash shown in the balance sheet.

The Cash Flow Statement is linked to the Income Statement and the Balance Sheet, and together, they provide a complete picture of a company’s financial health.

Consider Prim Corporation.

Its net income is the starting point for the cash flow statement under the operating activities section.

Because depreciation is a non-cash expense, Prim Corporation adds it back to net income on the cash flow statement.

Prim Corporation considers the changes in current assets and current liabilities that impact its cash flow.

If accounts receivable increase, then cash has not yet been received from customers, reducing its operating cash flow.

Prim Corporation also reflects changes in long-term assets, such as the purchase of machinery, reducing its investing cash flow.

It also considers changes in liabilities and equity, such as raising new stock, increasing its financing cash flow.

After these adjustments, the net cash balance in the cash flow statement reconciles with the cash shown on the balance sheet.

Together, these financial statements provide a full picture of Prim Corporation’s performance.