Every financial model rests on three statements: the P&L, the Balance Sheet, and the Cash Flow Statement. Most beginners learn them as separate documents. The breakthrough — and the foundation of all serious financial analysis — is realising they're not separate at all. They're three views of the same business, wired tightly together. Once you can see the wiring, modelling stops feeling like magic.
If you're starting your financial modelling journey, this is the best place to begin. Together, these three statements give a complete picture of a company's financial health — and understanding how they connect is the foundation of all financial analysis. Let's walk through each one.
I.The Profit and Loss Statement
The P&L captures a company's financial activity over a given period — typically a quarter or a financial year. Think of it as the company's scorecard for that time frame.
Revenue (the "Top Line")
The first line item is Revenue, which is why it is often called the top line. Revenue represents the value of goods or services sold during the period.
Cost of Goods Sold and Gross Profit
From Revenue, we deduct the Cost of Goods Sold (COGS) — all the direct costs involved in producing the goods or services. This gives us:
Operating Expenses and EBIT
After Gross Profit, we deduct Selling, General & Administrative expenses (SG&A) as well as any other operating expenses or income. This brings us to Operating Profit, also known as EBIT (Earnings Before Interest and Tax).
EBITDA
Another widely used metric is EBITDA — Earnings Before Interest, Tax, Depreciation, and Amortisation. To arrive at EBITDA, we add Depreciation and Amortisation (D&A) back to EBIT. Note that D&A may be disclosed separately, or it may be embedded within COGS or SG&A.
Non-Operating Items, PBT, and Net Income
Below EBIT, we account for interest income, interest expenses, and other non-operating or exceptional items. A note of caution: some companies include interest income and certain non-operating income within their reported Revenue — these should be excluded when calculating EBIT and EBITDA.
After netting off interest expenses and adding back interest income, we reach Profit Before Tax (PBT), sometimes called EBT. Deducting the tax charge from PBT gives us Profit After Tax (PAT), also known as Net Income — or the bottom line.
With that, we've covered the key lines of the P&L. Now to the Balance Sheet.
II.The Balance Sheet
While the P&L covers activity over a period of time, the Balance Sheet is a snapshot — it shows the company's financial position on a specific date.
The Balance Sheet has two sides: the Asset side (what the business owns) and the Liabilities side (what it owes). The two sides must always be equal. This is a critical principle to keep in mind when building financial projections.
Assets
Assets are split into two categories:
- Current Assets — assets with a life of less than 12 months. These include working capital items such as inventory and receivables, cash and cash equivalents, and short-term investments.
- Non-Current Assets — longer-term assets, with the most significant item typically being Property, Plant & Equipment (PP&E). Companies may also carry Capital Work-in-Progress (for assets under construction) and intangible assets, though the size of intangibles varies considerably by industry.
Liabilities
Liabilities are similarly divided into current and non-current:
- Current Liabilities — obligations due within 12 months, including accounts payable, other current liabilities, taxes payable, short-term debt, and the current portion of long-term debt.
- Non-Current Liabilities — longer-term obligations, primarily long-term debt and lease liabilities (which are treated similarly to debt), along with any other long-term payables.
Equity
The third component of the Liabilities side is Equity — the residual interest belonging to shareholders. Equity comprises two key elements: paid-in capital and retained earnings (or accumulated losses).
Retained Earnings is the critical link between the P&L and the Balance Sheet: Net Income (PAT), less any dividends paid, is added to Retained Earnings each period.
Now to the final statement.
III.The Cash Flow Statement
Like the P&L, the Cash Flow Statement covers a period of time. It is the linking statement between the P&L and the Balance Sheet, reconciling accounting profit with actual cash movements. It is divided into three sections.
Cash Flow from Operating Activities (CFO)
The typical starting point is Profit After Tax (PAT) or Profit Before Tax (PBT). From there, all non-cash and non-operational items are adjusted out, including Depreciation and Amortisation, exceptional items, provisions, and net financing costs.
Next, changes in working capital are incorporated — movements in receivables, inventory, payables, and other current assets and liabilities. As a general rule: if assets are increasing, they are consuming cash; if liabilities are increasing, they are releasing cash. Finally, if the starting point is PBT, then the actual taxes paid are deducted to arrive at CFO.
Cash Flow from Investing Activities (CFI)
This section captures the company's investment activity. The primary item is capital expenditure (stated as "purchases of property, plant, and equipment"). It also includes proceeds from asset disposals, interest income received, dividends received, and any purchases or sales of investments.
Cash Flow from Financing Activities (CFF)
This section covers the company's fund-raising and capital-return activities: equity issuances or share buybacks, debt raised and repaid, interest paid, and dividend payments.
The sum of CFO, CFI, and CFF gives the net increase or decrease in cash for the period.
IV.How the Three Statements Connect
This is the most important idea in this primer, and the one beginners most often miss. The three statements are not three separate documents — they are three views of the same business, and they are tightly wired together. Once you can see the wiring, financial modelling stops feeling like magic.
There are two main links to understand:
- Profit flows into the Balance Sheet. Net Income (PAT) from the bottom of the P&L, minus any dividends paid, is added to Retained Earnings within Equity. So this period's profit increases the company's net worth.
- Cash flow connects the P&L to the Balance Sheet. The Cash Flow Statement starts from profit and adjusts it back to actual cash. The net cash figure it produces is exactly the change in the Cash line on the Balance Sheet from the start of the period to the end.
Because of these links, the Balance Sheet stays balanced automatically. If the model is built correctly, every change on the P&L and Balance Sheet will find its way to the Cash Flow Statement. During projections, you can use cash balances or debt amounts to balance the Balance Sheet.
Following Depreciation Through All Three Statements
Depreciation is the perfect example of an item that touches all three statements at once. Imagine a company records $100 of depreciation in a period:
- On the P&L, depreciation is an expense, so it reduces profit (and therefore reduces Net Income).
- On the Balance Sheet, the $100 reduces the value of Property, Plant & Equipment on the Asset side. At the same time, the lower Net Income reduces Retained Earnings on the Equity side by the same amount — so the Balance Sheet stays in balance.
- On the Cash Flow Statement, depreciation is added back, because no actual cash left the business — it is purely an accounting entry. So it lowers profit but does not lower cash.
Trace one item through all three statements like this and the connections become intuitive. Once you can do it for depreciation, try it for a sale made on credit, or for repaying a loan — each one ripples through the statements in its own way.
V.Common Beginner Mistakes
As you start working with the statements, watch out for these common pitfalls:
- Confusing profit with cash flow. A company can be profitable on paper yet run short of cash, often because of working capital or capital expenditure.
- Assuming EBITDA equals cash flow. EBITDA ignores taxes, working capital changes, and capital expenditure, so it can differ substantially from actual cash generated.
- Forgetting that the Balance Sheet must always balance. If Assets do not equal Liabilities plus Equity, there is an error somewhere in the model.
- Ignoring working capital when forecasting. Changes in receivables, inventory, and payables can have a large effect on cash, even when profit looks stable.
VI.An Exercise
Now that you've been introduced to the three statements, here is a practical exercise to reinforce your understanding. Pick three companies and review their financial statements. For each company, answer the following questions:
- In the P&L, are there any line items you notice that were not covered in this article?
- On the Balance Sheet, which is the largest item on the Asset side?
- How does the company's CFO compare to its EBITDA, and what might explain the difference? (Think working capital and cash taxes.)
- Is Equity higher than Total Debt?
Conclusion
Every financial model is ultimately a forecast of these three statements working together. The P&L tells you how profitable the business was. The Balance Sheet shows what it owns and owes at a point in time. The Cash Flow Statement reconciles the two by tracking the actual movement of cash.
Mastering these three statements — and the wiring between them — is the first step toward becoming an effective financial analyst or modeller. Everything that follows is just refinement.