Quick Answer
A financial-statement model links three statements: the balance sheet (assets, liabilities, equity at a point in time), the income statement (revenue through net income over a period), and the cash flow statement (operating, investing, and financing flows that reconcile beginning and ending cash). Models draw on financial accounting and statistics, then feed spreadsheets, graphs, and valuation platforms.
Every ratio, multiple, and valuation built later in this unit rests on three financial statements. The exam tests the components of each statement and how they tie together.
What Are the Balance Sheet Components?
The balance sheet is a snapshot of what the company owns, what it owes, and what's left over for shareholders at a point in time.
| Block | Line Items |
|---|---|
| Current assets | Cash and cash equivalents; marketable securities; inventory; accounts receivable |
| Long-term assets | Property, plant and equipment (PP&E); goodwill and intangibles; deferred assets |
| Current liabilities | Accounts payable; short-term debt; accruals |
| Long-term liabilities | Long-term debt; deferred liabilities |
| Stockholders' equity | Preferred stock; common stock; additional paid-in capital; retained earnings; capital surplus |
The balance sheet identity:
Stockholders' equity is also called net worth or book value. It is the residual claim after every creditor has been paid.
Exam Tip: Gotchas
- PP&E means property, plant and equipment, not "property, plant and earnings" or "production, processing and equipment." The exam writes the abbreviation expecting candidates to know the expansion.
What Are the Income Statement Components?
The income statement runs from top to bottom over a period (quarter or year), starting with revenue and ending with net income.
- Revenue / sales (top line)
- Cost of goods sold (COGS): split into fixed costs (overhead that doesn't move with volume) and variable costs (move with units sold)
- Selling, general and administrative (SG&A) expenses
- Depreciation, amortization, and depletion (D&A): non-cash allocation of long-lived asset cost across useful life
- Operating income / loss: equals earnings before interest and taxes (EBIT)
- Interest income / expense
- Taxes
- Net income / loss (bottom line)
Think of it this way: The income statement is a waterfall. Revenue at the top, costs subtracted in layers, profit at the bottom. EBIT is the profit from running the business. Net income is what's left for shareholders after creditors and the tax authority take their cut.
Exam Tip: Gotchas
- D&A is non-cash. It reduces reported net income but does not reduce cash. That's why the cash flow statement adds it back to compute CFO.
What Are the Cash Flow Statement Components?
The cash flow statement (CFS) explains how cash on the balance sheet changed during the period. It is organized into three sections.
| Section | What It Captures |
|---|---|
| Operating cash flow (CFO) | Cash from running the business: net income adjusted for non-cash items (D&A) and working capital changes |
| Investing cash flow (CFI) | Capital expenditures (CapEx), acquisitions, divestitures, asset sales |
| Financing cash flow (CFF) | Debt issuance and repayment, equity issuance and buybacks, dividends paid |
The sum of CFO, CFI, and CFF equals the change in cash for the period.
How Do the Three Statements Tie Together?
The statements are not independent: they share line items that flow between them.
- Net income from the income statement flows into the cash flow statement as the starting point for CFO, and into the balance sheet as an addition to retained earnings
- Depreciation on the income statement reduces PP&E on the balance sheet and is added back as a non-cash item on the cash flow statement
- Cash on the balance sheet equals beginning cash plus the total change in cash from the cash flow statement
- Debt issued or repaid on the cash flow statement (financing section) changes the long-term debt line on the balance sheet
Exam Tip: Gotchas
- Net income flows three places at once: bottom line of the income statement, top line of the cash flow statement (CFO start), and an addition to retained earnings on the balance sheet. Models that don't tie back to all three places have an error somewhere.
- Cash on the balance sheet equals beginning cash plus the total change in cash from the cash flow statement. That tie-out is the standard check on a built model.
What Should You Check on Exam Day?
- Recall the balance sheet identity: Assets = Liabilities + Stockholders' Equity.
- Trace net income through all three statements: income statement bottom line, CFO starting point, and retained earnings addition.
- Remember D&A is non-cash on the income statement but gets added back on the cash flow statement.
- Confirm CFO + CFI + CFF equals the period's change in cash.