You will be able to follow how profit, cash and the balance sheet connect from one year to the next.
Every figure on one financial statement either comes from another statement or turns up on one, and being able to trace each figure across is the skill a financial model rests on. Once you can do that, a forecast is about one business seen three ways instead of a guess about three separate things.
Marcus had read Larkspur's income statement, balance sheet and cash flow statement many times, always as three separate pages. Each one made sense to him on its own, but he could not look at a number on one page and say where it came from on another. Larkspur is a made-up company, and all its figures here are invented examples, in S$ millions. The year traced is FY5, Larkspur's fifth year of figures.
The income statement covers a period. It starts with revenue, takes away costs and ends with net profit. In FY5 Larkspur had revenue of 400 and net profit of 48.
The balance sheet is a snapshot at the end of the period. Assets sit on one side and liabilities and equity on the other. The two sides always match, because every asset is funded either by someone the company owes or by its shareholders.
The cash flow statement explains the change in cash between two balance sheets. It sorts cash movements into three groups: operating, investing and financing.
Equity is the link between the income statement and the balance sheet. Net profit belongs to shareholders, so it adds to equity, specifically to retained earnings, the part of equity that profit adds to and dividends reduce. Dividends paid to shareholders reduce equity. Issuing or buying back shares also changes equity, through share capital or a reserve. Larkspur did neither in FY5.
To build the equity bridge, start with opening equity, add net profit for the year, subtract dividends, adjust for any share issues or buybacks, and compare the result with closing equity on the balance sheet. Larkspur's equity at the end of FY4 was 255. Adding the 48 of profit and subtracting the 18 of dividends gives 255 + 48 - 18 = 285, which matches the FY5 balance sheet equity of 285. On a real company the simple bridge may not match. When it doesn't, the equity statement in the annual report shows the other movements.
The bottom line of the cash flow statement must equal the change in the cash line on the balance sheet, every year, with no exceptions. Take operating, investing and financing cash flow, add them together, and confirm the total equals that change.
Larkspur's cash was 50 at the end of FY4 and 60 at the end of FY5, a change of 10. Operating cash flow was 66. Investing cash flow was minus 24: 34 spent on equipment and buildings, offset by 10 received from selling a property. Financing cash flow was minus 32: 10 of bank debt repaid, 4 of lease principal paid and 18 of dividends. The total is 66 - 24 - 32 = 10, and cash rose from 50 to 60.
Profit and cash differ because some expenses do not use cash in the year they are charged, and some cash goes out without touching profit. The biggest non-cash expense is depreciation, the cost of equipment spread over the years it is used. It reduces profit, but no cash leaves when it is charged; the cash left when the equipment was bought. Depreciation also applies to right-of-use assets from leases. Larkspur's FY5 depreciation was 24: 20 on equipment and 4 on right-of-use lease assets.
Operating cash flow starts with net profit of 48 and works through these adjustments:
Add back depreciation, including on right-of-use assets: plus 24. Subtract gains on asset sales: minus 6. The gain on selling the property is included in profit, but the cash from the sale belongs in investing cash flow, so the gain is removed here to avoid counting it twice. Subtract increases in receivables: minus 5. A rise in receivables is profit not yet collected. Add decreases in inventory: plus 2. A fall in inventory releases cash. Add increases in payables: plus 3. A rise in payables means Larkspur held on to cash it owed suppliers.
That gives 48 + 24 - 6 - 5 + 2 + 3 = 66. Lesson 7.3 explains working capital changes in full. Every item in this reconciliation is either a change in a balance sheet line or a figure from the income statement; nothing comes from nowhere.
The other balance sheet lines tie back the same way. The equipment line moves by opening balance plus spending minus depreciation minus the book value of assets sold. Larkspur's rose from 140 to 150: 140 + 34 spending - 20 depreciation - 4 book value of property sold = 150. Bank debt falls by the amount repaid, so it went from 70 to 60 with the 10 repaid. Lease liabilities rise with new leases signed and fall with lease principal paid. Larkspur's went from 22 to 20, with 2 of new leases signed and 4 of principal paid.
In a model, these lines are linked with formulas so that a change in one flows through all three statements. Sooner or later the balance sheet will not balance, with assets coming out a few million higher or lower than liabilities and equity.
Do not add an "other" line to make up the difference. That line is called a plug. It hides the error, and every forecast built on top of it inherits the error. A gap means a link is missing: a cash flow that did not reach the balance sheet, a balance sheet change that did not reach the cash flow statement, or a sign the wrong way round. Note the size of the gap, then look for a movement of the same size, or half the size if a sign is reversed. Then check each balance sheet line's change against the cash flow statement, one by one.
Marcus built a model of Larkspur, and on his first attempt the gap was exactly 4. The cause was the book value of the property sold, 4, which he had left out of the equipment line.
Take one year of your chosen company's accounts and trace it the same way: net profit through retained earnings to closing equity, and operating, investing and financing cash flow through to the change in cash.
Pick one year of your company's accounts. Follow net profit into retained earnings and through the cash flow statement.
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