$2,800 of profit. $2,600 of cash. Where did the money go?
The story so far You opened the shop on January 1 with $0 in its bank account. By December 31 your income statement says it earned $2,800, and your balance sheet says it has $2,600 of cash. But you also put in $1,200 of your own money and took out a loan. So how did the cash actually move? The third statement answers that: the cash flow statement. And once you see it, you'll see how all three statements fit together like gears.
The cash flow statement shows every dollar of cash that came in and went out over the year, sorted into three groups.
Profit can hide problems, as you saw in Lesson 11.2. Cash can't. Linking the three statements shows the full picture, and it's the core of every Wall Street financial model.
Start with net income, fix the parts that weren't cash, then add what you spent on equipment and what you borrowed or paid back.
Investment banking analysts build "three-statement models" that link them all. Corporate treasurers live in the cash flow statement. Auditors check that every link ties out.
What you're looking at: how the three statements hand numbers to each other. Net income from the income statement becomes the first line of the cash flow statement and adds to retained earnings on the balance sheet. The cash flow statement's ending cash becomes the cash line on the balance sheet.
Three statements, one story.
The income statement shows profit over a year. The balance sheet shows what you have on one day. The cash flow statement explains how cash got from last year's balance sheet to this year's.
The cash flow statement
The cash flow statement sorts every cash move into three groups: running the business, buying long-lasting things, and money from or to lenders and owners. Add the three, and you get the change in cash.
- The year
- $0 + $2,400 − $3,000 + $3,200 = $2,600. Each piece is below.
Operating activities
Cash from operating activities starts with net income, then fixes two things. First, add back depreciation: it was an expense, but no cash left this year for it. Second, adjust for working capital: money stuck in receivables or inventory didn't arrive as cash, and bills you haven't paid yet (payables) are cash you still have.
- Net income
- $2,800, from the income statement.
- Add back depreciation
- +$600. No cash left for it this year.
- Receivables went up
- From $0 to $1,000: −$1,000. A customer still owes it.
- Inventory went up
- From $0 to $1,000: −$1,000. Cash sitting on the shelf as parts.
- Payables went up
- From $0 to $1,000: +$1,000. Parts you have but haven't paid for yet.
- Cash from operations
- $2,800 + $600 − $1,000 − $1,000 + $1,000 = $2,400.
Investing activities
Investing activities are cash spent on long-lasting assets, or received from selling them. Buying equipment is called capital expenditures, or capex. Here's where the full price shows up, even though the income statement only counts the depreciation.
- The tool kit
- Paid in cash in January: −$3,000.
Financing activities
Financing activities are cash from or to lenders and owners: borrowing, paying back loan principal, owners putting money in, and paying owners out. Paying owners, called dividends at a corporation or draws at an LLC, isn't an expense: it lowers retained earnings directly.
- You put in
- +$1,200.
- The loan
- Borrowed $2,500, paid back $500: +$2,000. That leaves $2,000 owed, the loan on the balance sheet.
- Total financing
- $1,200 + $2,000 = $3,200.
Free cash flow
Free cash flow is the cash the business makes from operations after paying for the equipment it needs. It's what's truly free to pay down debt, pay the owners or grow. Investors value companies on it, as you'll see in Unit 13.
- Year one
- $2,400 − $3,000 = −$600. Normal for a first year: the tool kit was a one-time cost. Next year, with no new kit, it could be positive.
The links
Three numbers tie the statements together. Net income is the bottom of the income statement and the top of the cash flow statement, and it adds to retained earnings on the balance sheet. Ending cash on the cash flow statement is the cash on the balance sheet. And depreciation lowers net income, gets added back in operating cash, and lowers the equipment's book value.
- Net income
- $2,800 → top of cash flow, and retained earnings $0 + $2,800 = $2,800.
- Cash
- Cash flow ending cash $2,600 = balance sheet cash $2,600.
- Depreciation
- −$600 on the income statement, +$600 in operating cash, tool kit $3,000 → $2,400.
What you're looking at: all three of your statements for year one, linked. Matching colors are the same number showing up in two places: blue for net income, green for cash, gray for depreciation. Net income stays $2,800 while you move the sliders, but cash changes. That's the whole point.
Two minutes. Just listen.
Tap any line to jump to it.
Connect the dots.
Eight questions about how the three statements fit together. Each one gives you the numbers. One try each.
What you're looking at: made-up companies. Each lists a few numbers from its statements, then asks one question.
The logic, step by step.
To build a cash flow statement from the other two, run these four steps.
Step 1: Start with net income
- Start
- $2,800.
Step 2: Fix what wasn't cash
- Operating cash
- $2,800 + $600 − $1,000 − $1,000 + $1,000 = $2,400.
Step 3: Add investing and financing
- Investing and financing
- −$3,000 and +$3,200.
Step 4: Check that it ties
- Check
- $0 + $2,400 − $3,000 + $3,200 = $2,600. It ties.
Worked example: one $40 tune-up through all three
- What happens. A customer pays $40 cash for a tune-up that uses $10 of parts from the shelf.
- Income statement. Revenue +$40, COGS +$10, so net income +$30.
- Cash flow statement. Net income +$30, and inventory went down $10, which adds +$10. Operating cash +$40.
- Balance sheet. Cash +$40, inventory −$10: assets +$30. Retained earnings +$30: equity +$30.
- It ties. Cash rose $40 on both the cash flow statement and the balance sheet, and assets still equal liabilities plus equity.
A lake keeps its own books.
Hydrologists track a lake with two kinds of numbers. The water level on a given day is a stock, like a balance sheet. The rivers flowing in and out, rain and evaporation over the year are flows, like a cash flow statement. Last year's level plus all the flows always equals this year's level.
What you're looking at: an illustration, not data. A lake with a river flowing in on the left, rain from above, a river flowing out on the right, and a post that measures the water level.
Why this sticks. You can't explain why a lake is low by looking at today's level alone. You need the flows. A business is the same: the balance sheet tells you where cash ended up, and the cash flow statement tells you why.
The page you'd copy down.
- Cash flow statement: operating + investing + financing = change in cash. $2,400 − $3,000 + $3,200 = $2,600.
- Operating = net income + depreciation − more receivables − more inventory + more payables. $2,800 + $600 − $1,000 − $1,000 + $1,000 = $2,400.
- Investing: capex (equipment bought) −$3,000.
- Financing: owner money, borrowing, repayments, dividends or draws. $1,200 + $2,500 − $500 = $3,200.
- Free cash flow = operating cash − capex. $2,400 − $3,000 = −$600.
- Links: net income → cash flow top and retained earnings; ending cash → balance sheet cash; depreciation → added back, lowers book value.
Fill in the blanks
Grab a friend or a study group.
Pass the transaction
One person names a transaction. The next says what changes on the income statement, the next the balance sheet, the next the cash flow statement.
Find the links
Pull up a public company's three statements. Find net income in all three places it shows up, and check that ending cash matches.
Slider challenge
Using the statements above, find a setting where cash goes below zero while net income stays $2,800. What would you do about it?
Just you and your money.
These stay on this device. Nobody else sees them.
Exam-style questions.
Written the way a college exam would ask them. Each right answer on the first try is worth 10 xp.
On the job: you're an investment banking analyst
You're building a three-statement model for Northside Supply, a company your bank may help sell. Here's its year:
- Net income: $500,000. Depreciation: $100,000.
- Receivables went up $150,000. Inventory went up $50,000. Payables went up $30,000.
- Capex: $200,000 of new equipment.
- Loan principal repaid: $100,000. Dividends paid: $50,000.
- Cash at the start of the year: $300,000.
Your task: build the cash flow statement. What's the ending cash and the free cash flow? By how much did retained earnings change?
See a model answer
Operating: $500,000 + $100,000 − $150,000 − $50,000 + $30,000 = $430,000.
Investing: −$200,000. Financing: −$100,000 − $50,000 = −$150,000.
Ending cash: $300,000 + $430,000 − $200,000 − $150,000 = $380,000. That's the cash on the year-end balance sheet.
Free cash flow: $430,000 − $200,000 = $230,000.
Retained earnings: up $500,000 of net income, down $50,000 of dividends: +$450,000.
From accounting to valuing companies.
What you're looking at: a map of where this lesson fits in the course. Read it left to right: the lessons it builds on, this lesson in the middle, and the lesson that comes next.
- Back · Unit 12Did the business make money?
- Back · Unit 12What it owns, what it owes
- Back · Unit 11Profitable and still broke
- You are hereHow the three statements connect
- Next · Unit 13Raising money