The Three Financial Statements
The Three Financial Statements and How They Connect
LEARNING OBJECTIVES
IMPORTANCE
Every valuation starts here. The value of a business is built from line items that live in these three statements and flow between them. Anyone who cannot trace how a number travels between them is reading the output of a machine they do not understand.
The three statements are taught first because everything downstream depends on the triangle they form:
Profit, position, and cash are three different truths about the same business. The discipline begins with holding all three at once.
The central insight: Profit is an opinion, cash is a fact, and the balance sheet keeps the score.
INTELLECTUAL ORIGINS
The architecture predates modern finance. Double-entry bookkeeping was codified by the Franciscan friar Luca Pacioli in his Summa de Arithmetica of 1494, which formalised the rule that every transaction has two equal and opposite entries. That rule is why the balance sheet balances, and why the statements cannot drift apart.
The modern form rests on one identity and one principle:
Because earning and collecting happen at different times, profit and cash for the same period rarely match. The cash flow statement exists to reconcile them: it starts at net income, adds back non-cash charges, adjusts for changes, and arrives at real cash.
CORE FRAMEWORK
There are three statements, and three core bridges between them. Other links exist, but these three carry the lesson.
The three statements
The three bridges
The depreciation walk. Follow a single depreciation charge:
One expense, three statements, every number reconciling.
COMPARISON
| Income Statement | Balance Sheet | Cash Flow Statement | |
|---|---|---|---|
| Measures | Profitability | Financial position | Liquidity |
| Time frame | A period | A single instant | A period |
| Basis | Accrual | Cumulative | Cash |
| Key output | Net income | Assets = Liabilities + Equity | Net change in cash |
| Question | Was it profitable? | What does it own and owe? | Where did cash go? |
REAL COMPANY APPLICATION: NIKE, INC., FISCAL 2025
These figures show how the statements connect; they are not a valuation. The full model is in Equity Research, under the Nike analysis.
Profit flows into the balance sheet. Nike earned $3.2B of net income, yet its retained earnings stand at negative $0.7B. Both are true, and the bridge explains it: net income adds to retained earnings, while dividends and buybacks subtract. Over years, Nike returned more to shareholders than it kept. The minus sign is heavy capital return, not losses.
Investment and depreciation move the asset base. Nike's net property fell from $5.0B to $4.8B in a single year, because it spent less on property than it depreciated. It designs and markets but outsources manufacturing, so the asset base quietly shrinks. Capital spending builds property; depreciation wears it down; the balance sheet records the net.
Profit is not cash. Nike's operating cash differed from its profit, because depreciation and stock compensation are non-cash, and because billions of sales sat uncollected in receivables at year-end. The profit was booked; some of the cash had not yet arrived. The cash flow statement is what converts the one into the other.
The loop closes. Operating, investing, and financing flows net to the year's change in cash, and that figure carries straight onto the new balance sheet. Nothing is free-floating: every statement feeds the next.
HOW TO BUILD IT: THE THREE STATEMENTS, LINE BY LINE
The sections above show what each statement is and how the three connect. This section is the hands-on part: it builds all three, one line at a time, using Nike’s real fiscal-2025 figures (the year ended 31 May 2025). Follow it once here, and you will be able to open any company’s annual report and build the same skeleton yourself. All figures are in US dollars, rounded to the nearest tenth of a billion for readability; the exact numbers come from Nike’s FY2025 Form 10-K.
Build them in this order: the income statement first, because it produces net income. Then the cash-flow statement, because it starts from that same net income and adjusts it back to cash. The balance sheet comes last, because two of its lines, retained earnings and cash, are only finished once the other two statements are done. This order is not a rule of accounting; it is simply the order in which the numbers become available.
STEP 1, BUILD THE INCOME STATEMENT
The income statement answers one question: was the year profitable? You build it by starting with the money that came in from selling product, then subtracting the costs of the business in the order they occur, until only profit for the owners remains. It is a story of subtraction, top to bottom.
| Income statement (Nike FY2025) | $ billions | How you get the line |
|---|---|---|
| Revenue | 46.3 | Total sales of shoes, apparel and equipment for the year. |
| − Cost of sales | 26.5 | What it cost to make and ship the product sold. |
| = Gross profit | 19.8 | Revenue minus cost of sales. The margin before running the company. |
| − Selling & administrative expense | 16.1 | Marketing, stores, salaries, offices, the cost of running the business. |
| = Operating income | 3.7 | Profit from the core business, before interest and tax. |
| − Interest and tax (net) | ~0.5 | Nike earns interest on its cash and pays tax; the net effect here. |
| = Net income | ~3.2 | The bottom line, profit that belongs to shareholders. |
Line 1, Revenue. Start at the top with revenue, the total value of everything sold during the year: $46.3B for Nike. This is not cash collected; under accrual accounting, a sale is recorded when the product ships to the retailer, even if the cash arrives later. That timing gap matters, and the cash-flow statement will correct for it in Step 2.
Line 2, Cost of sales. Subtract what it actually cost to make and deliver the product that was sold: $26.5B. What remains, gross profit of $19.8B, is the money left after the product itself is paid for. Dividing gross profit by revenue gives the gross margin (19.8 ÷ 46.3 ≈ 43%), a first read on pricing power.
Line 3, Running the company. Now subtract the cost of operating the business, marketing, retail stores, salaries, head-office overhead: $16.1B in total. What is left, operating income of $3.7B, is the profit the core business earns before the financing and tax lines. This is the cleanest measure of how the business itself performed.
Line 4, Interest and tax. Finally, account for interest and tax. Nike holds more cash than debt, so it earns net interest; it then pays corporate tax on its profit. After those, net income lands at roughly $3.2B. That single number is the anchor of the next statement.
STEP 2, BUILD THE CASH-FLOW STATEMENT
The cash-flow statement answers a different question: where did the cash actually go? Profit and cash are not the same thing, because the income statement records sales before the money arrives and includes costs (like depreciation) where no money left. So you do not start this statement from scratch, you start from net income and adjust it back to real cash, in three blocks: operating, investing, and financing.
| Cash-flow statement (Nike FY2025) | $ billions | Why the adjustment |
|---|---|---|
| Net income (from Step 1) | ~3.2 | The starting point, carried straight down. |
| + Depreciation & amortisation | 0.8 | A cost on the income statement, but no cash left, add it back. |
| ± Changes in working capital | (0.3) | Cash tied up in unsold inventory and uncollected receivables. |
| = Cash from operations | 3.7 | The cash the core business truly generated. |
| − Capital expenditure | 0.4 | Cash spent on new property and equipment (investing). |
| = Free cash flow | 3.3 | Operating cash left after essential reinvestment. |
| − Dividends and buybacks | 5.3 | Cash returned to shareholders (financing). |
Block 1, Operating. Begin with net income of $3.2B. Add back depreciation and amortisation of $0.8B: it was subtracted as a cost in Step 1, but no cash left the business, so it must be returned here. Then adjust for working capital, the cash quietly tied up in inventory sitting in warehouses and in sales invoiced but not yet collected. Nike had billions in receivables outstanding at year-end, so some booked profit had not yet turned into cash. After these adjustments, cash from operations is $3.7B, close to net income here, but the two can diverge sharply.
Block 2, Investing. Subtract capital expenditure, the cash spent on new stores, equipment and property: $0.4B. Operating cash minus this essential reinvestment gives free cash flow of about $3.3B, arguably the single most important number in the whole model, because it is the cash genuinely available to owners.
Block 3, Financing. Finally, record cash paid out to lenders and owners. In FY2025 Nike returned $5.3B to shareholders, $2.3B in dividends and $3.0B in share buybacks. Because Nike returned more than it earned, cash fell over the year. Hold that fact; it is what makes the balance sheet look surprising in Step 3.
STEP 3, BUILD THE BALANCE SHEET
The balance sheet answers: what does the company own, and what does it owe, at one instant? Unlike the other two, it is not a story of a period, it is a photograph taken on the last day of the year. Its single unbreakable rule is the accounting equation: everything a company owns (assets) was paid for either by borrowing (liabilities) or by owners (equity). The two sides must be equal, always.
| Balance sheet (Nike, 31 May 2025) | $ billions |
|---|---|
| ASSETS, what Nike owns | |
| Cash & short-term investments | 9.2 |
| Accounts receivable (owed by customers) | 4.7 |
| Inventories (unsold product) | 7.5 |
| Net property & equipment | 4.8 |
| Other assets | 10.4 |
| = Total assets | 36.6 |
| LIABILITIES & EQUITY, who funded them | |
| Total liabilities (owed to others) | 23.4 |
| Shareholders’ equity (owners’ stake) | 13.2 |
| = Total liabilities + equity | 36.6 |
The asset side. List what Nike owns, most-liquid first: $9.2B of cash and short-term investments, $4.7B of receivables (money customers owe for product already shipped), $7.5B of inventory (product made but not yet sold), and $4.8B of net property and equipment (stores, distribution centres, offices, after depreciation). These plus other assets total $36.6B.
The funding side. Every one of those dollars of assets was funded somehow. $23.4B came from liabilities, money owed to suppliers, lenders and others. The remaining $13.2B is shareholders’ equity, the owners’ residual claim. The two sides meet exactly at $36.6B, as they must.
The line that surprises people. Inside that $13.2B of equity, retained earnings are negative $0.7B, even though Nike has been profitable for decades. This is not a loss. Retained earnings rise with net income and fall with dividends and buybacks. Over many years Nike has returned more cash to shareholders than it kept, and FY2025, when it earned $3.2B but paid out $5.3B, pushed the cumulative figure below zero. The minus sign is the fingerprint of heavy capital return, not weakness.
STITCH THEM TOGETHER: THE THREE BRIDGES, IN NUMBERS
The three statements are not three separate documents; they are one system seen from three angles. Three bridges lock them together, and now you can see each one in Nike’s actual figures.
Bridge 1, Profit flows into equity. Net income from Step 1 ($3.2B) lands in retained earnings on the balance sheet, then dividends ($2.3B) and buybacks ($3.0B) are subtracted. Because $5.3B out exceeds $3.2B in, retained earnings fell over the year. The income statement and the balance sheet meet here.
Bridge 2, Spending flows into assets. Net property began the year near $5.0B. Capital expenditure from the cash-flow statement ($0.4B) adds to it; depreciation ($0.8B) wears it down. Because Nike spent less than it depreciated, net property drifted down to $4.8B. The cash-flow statement and the balance sheet meet here.
Bridge 3, One depreciation charge, all three statements. Depreciation is subtracted as an expense on the income statement (lowering profit and tax), added straight back on the cash-flow statement (because no cash left), and on the balance sheet it lowers net property while the tax saving lifts cash. One number, moving through all three at once, the clearest proof that the statements are a single machine.
Now you can build one yourself. Open any company’s annual report and repeat these three steps: subtract down the income statement to net income; start the cash-flow statement from that net income and adjust back to cash; then lay out the balance sheet and confirm assets equal liabilities plus equity. If the three bridges reconcile, your skeleton is sound, and you are reading the company the way an analyst does.
LIMITATIONS
The framework is an accounting model, not the underlying economics, and it has blind spots:
COMPETING VIEWS
The disciplined position reads the three together, never ranked. The income statement explains earning power, the balance sheet explains resilience, the cash flow statement explains survival. A company can be profitable and bankrupt at once: book large credit sales, sink the cash into inventory and receivables, fail to pay suppliers, and you are profitable on paper and insolvent in the bank. Cash, not profit, pays the bills.
IN SUMMARY
The three statements form one connected system. The income statement reports accrual profit over a period, the balance sheet reports position at an instant, and the cash flow statement reconciles the two by tracking real cash. Net income flows into retained earnings, capital spending builds the asset base while depreciation wears it down, and a single depreciation charge moves all three while keeping the sheet balanced. Master these linkages, and every later tool, from free cash flow to the discounted cash flow model, becomes the assembly of parts you already understand.
RELATED TOPICS
Pillar 2, Income Statement Deep Dive. The revenue-to-net-income walk, line by line.
Pillar 3, Balance Sheet Deep Dive. Working capital, net debt, and capital structure.
Pillar 4, Cash Flow and Free Cash Flow. Free cash flow, the value that ultimately reaches owners.
Pillar 8, DCF Modeling. The full machine, assembled from these three statements.
FURTHER READING
REFLECTION QUESTIONS
Accrual accounting records the economic event, not the cash that follows it. A sale is booked when the product is delivered, even if the customer pays months later; a cost is booked when it is incurred, even if the bill is paid next quarter. This is what makes the income statement informative, and it is also why profit and cash differ.
Of the $46,309M of revenue Nike reported in fiscal 2025, $4,717M was still in accounts receivable at year-end, recognised as sales, not yet collected. The profit was earned on paper; some of the cash had not arrived.
Because every reported profit is an accrual figure shaped by judgement, valuation never trusts earnings alone. It traces them back to cash, which is exactly what the cash flow statement exists to do.
The cash a business has locked into its day-to-day cycle: it pays for inventory and waits to be paid by customers, while delaying its own payments to suppliers. Broadly it is current assets minus current liabilities; the operational lens that matters for cash flow strips out cash and debt, leaving receivables and inventory net of payables. When it rises, cash is absorbed; when it falls, cash is released.
At fiscal 2025 year-end Nike held $23.4B of current assets against $10.6B of current liabilities, positive working capital of $12.8B. Within that, the operating items, $4,717M of receivables and $7,489M of inventory against $3,479M of payables, about $8.7B, are what tie up cash and move through the cash flow statement. As Nike rebuilt its wholesale channel, receivables rose, absorbing cash even as profit held.
Positive vs negative
A business with positive working capital ties cash up as it grows. One with negative working capital, a model that collects before it pays, releases cash as it grows.
Changes in working capital are subtracted in free cash flow, so a business that ties up little as it grows is worth more, all else equal, than one that ties up a lot.
What the business earns from running its operations, before how it is financed and where it is taxed. It sits between gross profit and net income, and by removing financing and tax it isolates operating performance. Unlike EBITDA, it still subtracts depreciation, so it respects the cost of using assets.
Nike, fiscal 2025: $46,309M revenue − $26,519M cost of sales = $19,790M gross profit; − $16,088M selling and admin = $3,702M operating income, an 8.0% margin.
It drives the EV/EBIT multiple and, after tax, begins the unlevered free cash flow in a DCF. For asset-heavy businesses, where depreciation is real, it is the fairer profit measure.
The first and most important section of the cash flow statement: the actual cash the core business produced. It starts from net income and works back to cash, adding non-cash charges like depreciation and stock-based compensation, then accounting for the cash absorbed or released by working capital.
Nike turned $3,219M of net income into $3,698M of operating cash flow in fiscal 2025: $775M of depreciation and $709M of stock compensation added back, partly offset by cash tied up in working capital.
It is the truest near-term test of whether a business funds itself, because debt, dividends, and survival are paid in cash, not profit. It is also the raw material of free cash flow.
The bottom line of the income statement: what remains once the direct cost of goods, operating expenses, interest, and tax have come out of revenue. It is the basis of earnings per share, but it is an accrual number, carrying non-cash charges like depreciation and omitting real cash like capital spending, so it describes profitability, not the cash produced.
Nike, fiscal 2025: $3,702M of operating income, then net interest, other items, and a $666M tax charge, leaving $3,219M of net income, or $2.16 per diluted share.
It feeds the price-to-earnings multiple and flows into retained earnings, but because financing, tax, and one-offs all shape it, it is normalised before it is trusted, and always checked against cash.
The equity account that links every income statement to the balance sheet. Net income flows in each year; dividends flow out, and so do buybacks where the shares are retired, as Nike does, while some companies instead hold buybacks in a separate treasury-stock account. The balance carries forward. It is not a pile of cash, but a record of how much profit has been kept rather than returned.
Nike began fiscal 2025 with $965M, added $3,219M of net income, then returned $2,337M in dividends and charged $2,613M of buybacks against the account (a small employee-share issuance nets the rest), ending at negative $727M. A company that earned $3.2B can still show negative retained earnings, not from weakness but from returning more to shareholders than it keeps.
The roll-forward is one of the clearest windows into capital allocation: whether management reinvests profit, pays it out, or buys back stock.
The cash a company invests in physical assets that serve it for years. It sits in the investing section of the cash flow statement and adds to property on the balance sheet, where depreciation wears it down.
Two kinds
Maintenance capex keeps existing assets running.
Growth capex expands capacity.
Nike spent just $430M in fiscal 2025, well below its $775M depreciation charge, it invests less in property than it wears out, because it designs and markets but outsources manufacturing. Its net property base actually shrank over the year.
CapEx is the gap between operating cash flow and free cash flow, so it sits at the heart of valuation. A capital-light business converts far more of its profit into distributable cash than a capital-heavy one.
When a company buys a long-lived asset, the cash leaves at purchase, but the cost is spread across the years it is used, depreciation for physical assets, amortisation for intangibles. The charge lowers profit each year without any cash leaving, which makes it the clearest proof that one entry moves all three statements at once.
Across the three statements, following Nike's $775M charge in fiscal 2025
Income statement: lowers operating and pre-tax income, and so lowers tax.
Cash flow statement: the full $775M is added back to net income, because no cash left.
Balance sheet: accumulated depreciation rises, net property falls, cash rises by the tax saved.
Only the tax it saves is real cash, a core reason profit and operating cash flow diverge. It is added back to reach cash flow, but a business must eventually spend real capital to replace what it depreciates, which is why free cash flow, not EBITDA, is the honest measure.