interview question
The three financial statements- Income Statement, Balance Sheet and Cash Flow Statement are closely connected and dependent on each other.
They are not prepared in isolation, but rather form a continuous flow of financial information.
For better understanding, we will first get a brief understanding about the above listed financial statement
Balance Sheet
A Balance Sheet is a financial statement that shows the financial position of a business at a particular point of time. It reflects what the business owns (assets) and what it owes (liabilities), and the difference between them represents the owner’s capital. It is based on the accounting equation:
Assets = Liabilities + Capital, which always remains balanced.
The Balance Sheet includes assets such as cash, inventory, machinery and furniture, while liabilities include loans and creditors. The capital represents the owner’s investment along with accumulated profits.
Example: If a business has,
| ASSETS | AMOUNT | LIABILITIES | AMOUNT |
|---|---|---|---|
| Cash | 25,000 | Capital | 40,000 |
| Machinery | 35,000 | ||
| Stock | 10,000 | ||
| 70,000 | 40,000 | ||
- It is called a snapshot of financial position at a specific date
Cash Flow Statement
A Cash Flow Statement is a financial statement that shows the actual inflow and outflow of cash and cash equivalents during a period. It focuses only on real cash transactions and ignores non-cash and credit items. It is very important for understanding the liquidity position of a business.
It is divided into three main activities: operating activities (day-to-day operations), investing activities (purchase and sale of assets), and financing activities (capital and borrowings).
Example:
A business shows:
- Profit = ₹60,000
But:
-
₹20,000 is not yet received
-
₹15,000 spent on machinery
Actual cash available is much less
- Profit does not always mean availability of cash
Income Statement
An Income Statement is a financial statement that shows the profit or loss of a business for a specific period by comparing total revenue and total expenses. It helps in understanding whether the business is earning or not.
Example:
-
Sales = ₹1,00,000
-
Expenses = ₹60,000
Profit = ₹40,000
- If expenses were more than sales - it would show a loss.
Let’s understand the connection now
Income Statement and Balance Sheet Connection
The Income Statement shows the profit or loss earned during a particular period, whereas the Balance Sheet shows the financial position at a specific point of time. The connection between them lies in the treatment of profit.
When a business earns profit, it is not kept separately. Instead, it is added to the owner’s capital in the Balance Sheet, thereby increasing the net worth of the business. Similarly, if the business incurs a loss, it reduces the capital.
This means:
-
Profit = increase in capital
-
Loss = decrease in capital
So, the result of Income Statement directly affects:
- Owner’s Equity or Retained Earnings
For Example:
Suppose a business earns:
-
Revenue = ₹1,20,000
-
Expenses = ₹80,000
-
Profit = ₹40,000
This ₹40,000 will be:
-
Added to capital in Balance Sheet
-
Increasing overall financial strength
Hence, the Income Statement acts as a link that updates the Balance Sheet after every period.
Income Statement and Cash Flow Statement Connection
The connection between these two statements is slightly more technical, because both deal with different concepts.
The Income Statement is prepared on the basis of the accrual concept,
The Accrual Concept is an accounting principle which states that income and expenses are recorded when they are earned or incurred, not when cash is actually received or paid. In simple words, it focuses on the real activity of business, not just cash movement.
This means that even if money has not come in or gone out, the transaction will still be recorded in the books if it relates to that period. The main aim of this concept is to show the true profit or loss of a business.
This means it includes:
-
Credit sales (not yet received)
-
Outstanding expenses
-
Non-cash items like depreciation
On the other hand, the Cash Flow Statement records only actual cash inflows and outflows. Therefore, the Net Profit from Income Statement becomes the starting point for preparing the Cash Flow Statement.
But since profit is not equal to cash, certain adjustments are required.
Adjustments include:
-
Adding back non-cash expenses like depreciation
-
Deducting credit income not yet received
-
Adjusting changes in working capital (debtors, creditors, stock)
Let us take an example:
-
Net Profit = ₹50,000
-
Includes ₹15,000 credit sales (not received)
-
Includes ₹5,000 depreciation
Actual cash will be different from ₹50,000
So, Cash Flow Statement:
-
Starts with ₹50,000
-
Adjusts these items
-
Shows real cash generated
Hence, it converts accounting profit into actual cash position
Cash Flow Statement and Balance Sheet Connection
The Cash Flow Statement is directly linked with the Balance Sheet through the cash balance.
The Balance Sheet shows:
-
Opening cash balance
-
Closing cash balance
But it does not explain the change. This is where Cash Flow Statement comes in.
It shows:
-
How much cash came in
-
How much cash went out
-
Reasons for increase or decrease in cash
Flow:
-
Opening Cash (Balance Sheet)
-
Cash Inflows – Cash Outflows = Closing Cash (Balance Sheet)
Example:
| PARTICULERS | AMOUNT |
|---|---|
| opening cash | 10,000 |
| add: cash inflows | +30,000 |
| less: cash outflows | -15,000 |
| Closing cash | 25,000 |
This ₹25,000 will be shown as closing cash in the Balance Sheet
All three statements are interconnected and must be read together:
-
Income Statement to show profitability
-
Cash Flow Statement shows liquidity (real cash)
-
Balance Sheet shows financial position
Connection in brief:
-
Profit from Income Statement → added to Balance Sheet
-
Same profit → adjusted in Cash Flow Statement
-
Cash Flow → explains change in Balance Sheet cash
Therefore, these statements together provide a complete and accurate picture of business performance and position.