Accounting & analysis
How the three statements connect
Net income flows into equity, depreciation and working capital bridge profit to cash, and the balance sheet must balance.
Definition
The three statements are mechanically linked. Net income from the income statement closes into retained earnings on the balance sheet. Depreciation is added back in the cash flow statement, while changes in receivables, inventory, and payables explain the gap between accrual profit and operating cash.
Because of those links, a change in one driver propagates everywhere. Raise revenue and you raise profit, tax, receivables, equity, and cash together, which is what the statement playground demonstrates.
Intuition
Follow the money: profit lands in equity, non-cash charges come back out, and working-capital movements either release or absorb cash.
When to use it
- Explaining why profit and cash differ.
- Forecasting how growth consumes working capital before it produces cash.
When not to use it
- Assuming the depreciation add-back means cash is healthy: it is a non-cash charge, not a source of cash.
Formula
Operating cash flow (indirect method)
OCF = Net income + Depreciation − ΔReceivables − ΔInventory + ΔPayables
Bridges accrual profit to cash from operations.
Worked example
From profit to operating cash
Net income 150,000; depreciation 120,000; receivables rose 40,000; inventory rose 30,000; payables rose 20,000.
- 1
Start with profit
150,000.
- 2
Add back non-cash
+120,000 depreciation = 270,000.
- 3
Working capital
−40,000 − 30,000 + 20,000 = −50,000.
Operating cash flow = 220,000, comfortably above net income because depreciation is large.
Measured by
These scoreboard metrics track or interpret this idea across the Lab.
Common mistakes
- Forgetting that growth in receivables or inventory absorbs cash.
- Sign errors on working-capital movements: an increase in an asset is a use of cash.
- Double-counting depreciation by adding it back twice.
How it connects
is an advanced form of
The source extends the target once the basics are secure.
relates to
Useful to study together, in either order.
requires
Learn the source first; the target assumes it.