Three Way Integrated Financial Statements

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Link the three financial statements together and explain how it flows through.

Quick reference

Three Way Integrated

Understand the links between the Financial Statements.

When to use

It is necessary to understand the links between the Financial Statements when building a Financial Model.

Instructions

  • Two links between the three financial statements
    • The net profit after tax in the income statement, has to link to the actual opening retained profits or net profit after tax in the equity section of the balance sheet.
    • Similarly, the actual net increase or decrease in cash held from the cash flow statement has to link through to its counterpart in the balance sheet in the income and taxes section.
    • All other links sourced from calculations
  • Conceptual order: Income Statement (smallest) --> Cash Flow Statement (middle) --> Balance Sheet (largest).
  • As long as the Net Profit After Tax links into the Retained Earnings section of the Balance Sheet and the Net Increase / Decrease in Cash Held from the Cash Flow Statement links into the Current Assets section of the Balance Sheet, you have all of the links you require to put a financial model together.

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  • 00:04 Having looked at the three types of financial statement,
  • 00:07 the next thing we need to consider before we actually get financial modeling
  • 00:11 underway is the concept of something called three-way integrated.
  • 00:15 Sounds a little kinky, I know, but
  • 00:17 actually it's quite rudimentary to how accounting works.
  • 00:21 Let me explain.
  • 00:22 So those are financial statement types.
  • 00:25 The next thing here is the meaning of three-way integrateds.
  • 00:28 It's like an elephant, let's never forget, and move on.
  • 00:32 Believe it or not, to link up the three financial statements so
  • 00:36 that the balance sheet will always balance and actually give you the numbers,
  • 00:39 we actually only require two links between the financial statements.
  • 00:44 I kid you not.
  • 00:45 The net profit after tax,
  • 00:47 in the income statement, has to link to the actual opening retained profits,
  • 00:52 or net profit after tax in the equity section of the balance sheet.
  • 00:56 And, similarly, the actual net increase or
  • 00:59 decrease in cash held from the cash flow statement has to link through
  • 01:02 to its counterpart in the balance sheet in the income and taxes section.
  • 01:06 If you've got that, the financial statements are linked, and that's it.
  • 01:11 And, talking about links, There's a conceptual order to all this.
  • 01:17 Let's have three blocks please.
  • 01:19 A one, a two, a one, two, three, here we go.
  • 01:22 Three blocks, nice color scheme here.
  • 01:25 If you're color blind, you probably can't see those at all, but
  • 01:28 they are blue blocks on a foggy day.
  • 01:31 And the smallest one, believe it or not, is the income statement.
  • 01:35 Now what income statement?
  • 01:36 Well, believe it or not, conceptually,
  • 01:39 I believe this is the smallest of the three financial statements.
  • 01:42 Now let me explain.
  • 01:43 I don't mean that it's got smaller numbers than the others or
  • 01:46 it's just got fewer line items.
  • 01:48 I mean, conceptually,
  • 01:50 it considers less amount of company than either the other two financial statements.
  • 01:54 It just looks at the net operating profit, after tax, for a period of time.
  • 01:59 It's summarizing the balance sheet,
  • 02:01 which shows that the balance sheet must be larger.
  • 02:03 And also, because the cash flow statement also covers investing and
  • 02:06 financing, it's smaller, conceptually, than those two.
  • 02:10 Now because the balance sheet encapsulates the other two, then, arguably,
  • 02:13 the cash flow statement is the middle one, and the balance sheet is the final one.
  • 02:18 And if you ever been on one of my training courses,
  • 02:20 you'll hear this known as the Goldilocks analogy, where I call income statement,
  • 02:25 baby bear, cash flow statement, mommy bear, and balance sheet, daddy bear.
  • 02:30 Apologies to all the feminists and
  • 02:32 everybody else out there who believes everyone is created equal.
  • 02:35 I believe that, too, before you start writing in letters of complaint.
  • 02:40 But, no matter how equal they may be, I strongly recommend, when modeling,
  • 02:45 you begin with the income statement.
  • 02:46 Get that sorted out first, and then when you're looking at what's left in the cash
  • 02:50 flow statement and balance sheet, you won't come back to the income statement,
  • 02:53 because it's already finished off.
  • 02:54 It's already been sorted out.
  • 02:56 Similarly, when you finish off the cash flow statement, anything that's
  • 02:59 just left in the balance sheet won't fit the other two financial statements.
  • 03:02 Which is why it should be done in that order.
  • 03:04 The first two link in to the third, as I mentioned.
  • 03:08 If we surround that by building the checks architecture to begin with,
  • 03:11 when we put all this together so that we put numbers in and change anything,
  • 03:15 the balance sheet will always balance.
  • 03:17 This is known as three-way Integrated financial statements.
  • 03:21 And that's what your striving for when building a financial model.
  • 03:24 You want it to have the check architecture so you don't fall over.
  • 03:28 You want to build it in the order that you don't have to go back and redo things.
  • 03:31 And you want it to all link perfectly so you change something and it flows through.
  • 03:35 That's the whole conceptual order idea three-way integrated.

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