How the cash flow statement links to the other statements

Four statements, two kinds

The balance sheet shows what a company owns and how it is financed on one date. Its accounts are stocks: balances that carry over from one period to the next.

The other three primary statements are flows. The income statement reports revenue, expenses, gains and losses between two balance sheet dates, measured on an accrual basis, so it need not match cash. The statement of cash flows reports the change in cash, cash equivalents and restricted cash over the same period, sorted into operating, investing and financing activities. The statement of shareholders' equity explains how each equity account (share capital, retained earnings) moved during the period.

Put together, the three flow statements are the bridge between last year's balance sheet and this year's. Every change in a balance sheet account must be explained by one or more of them.

The two big reconciliations

The bottom of the cash flow statement starts from the cash balance on the opening balance sheet, adds the net cash flow from each of the three activities, and must land exactly on the cash balance of the closing balance sheet.

Retained earnings do the same job for profit. Net income from the income statement is added to opening retained earnings and dividends are deducted; the result is closing retained earnings. If the dividends were paid in cash, they also appear in the cash flow statement.

Because these identities always hold, you can solve for any one missing piece. Know opening and closing retained earnings and net income, and you know dividends. Know opening cash and the three activity totals, and you know closing cash.

Think of the balance sheets as two photographs and the flow statements as the film in between. The cash flow statement is the part of the film that only follows the cash.

Where accrual and cash part ways

Accrual accounting recognises revenue when it is earned and expenses when they are incurred. When the cash moves at a different time, the difference sits in a working capital account on the balance sheet.

Revenue earned but not yet collected raises accounts receivable. An expense incurred but not yet paid raises accounts payable or another accrued liability. Cash paid before the expense is recognised creates a prepaid expense (an asset). Cash received before the company delivers creates deferred revenue (a liability), which is removed and recognised as revenue once the company performs.

Each of these accounts follows the same roll-forward: opening balance + what the income statement added − what cash settled = closing balance. For receivables: opening receivables + revenue − cash collected from customers = closing receivables.

Why the links matter to an analyst

Tracing transactions through all three statements shows that the income statement alone can mislead. A company could book sales on credit to customers who will never pay: revenue and profit look healthy, but receivables balloon and operating cash flow stays weak.

So when profit grows but operating cash does not, look at the working capital accounts. Persistent divergence can signal aggressive revenue recognition or other accounting problems, not just a timing quirk.