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The three statements and how they link

Trace a real company's profit into its balance sheet and its cash, the first job an analyst is given, using Costco's latest annual report.

FinanceReading the accounts like an analystAbout 10 min: 9 reading, 1 practiceUpdated 28 October 2026

General education, not financial advice.

After this lesson you can

Say which question each of the three statements answers
Reconcile retained earnings from profit and payouts
Reconcile opening to closing cash and explain why operating cash differs from profit

Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.

Reading the accounts like an analyst: lesson 1 of 5

Reading the accounts like an analyst
The three statements and how they link 10 min
Common-size statements and trends 9 min
Profitability ratios: margins, ROA and ROE 9 min
Efficiency ratios and the cash conversion cycle 9 min
DuPont analysis: where ROE comes from 10 min

Pairs with any financial statement analysis or accounting text, such as the Corporate Finance Institute's Reading Financial Statements, modules 1–2

Mission

From: your manager, an investment research team Due: Friday

A client has read that Costco made 9.2 billion dollars last year, paid 2.5 billion in dividends, and yet its cash went up by 6 billion. They think the numbers don't add up. Take Costco's latest annual report (Form 10-K for the 52 weeks to 30 August 2026, filed 7 October 2026) and send me a half-page note that ties profit, retained earnings and cash together, so I can forward it.

The documents (from the 10-K; millions of dollars):

Statement of equity
Retained earnings, 31 Aug 2025	22,650
Net income	9,226
Cash dividend declared	(2,458)
Share buybacks charged to retained earnings	(827)
Retained earnings, 30 Aug 2026	28,591

Cash flow statement
Net income	9,226
Depreciation and amortisation	2,674
Other non-cash items (lease, stock-based pay, deferred tax, other)	1,597
Merchandise inventories	(1,153)
Accounts payable	2,755
Other operating assets and liabilities	718
Operating activities	15,817
Investing (incl. 6,435 on property and equipment)	(6,378)
Financing (incl. dividends 2,458, buybacks 848)	(3,355)
Exchange-rate effect	(38)
Cash: start → end of year	14,161 → 20,207

What it is

The toolkit for this job.

Three statements, three questions.

The income statement asks: did we make a profit over the period? Revenue counts when it's earned and expenses when they're incurred, not when cash moves (accrual accounting).
The balance sheet asks: what do we own and owe on one date? Assets = liabilities + equity.
The cash flow statement asks: where did the cash come from and go over the period? It sorts cash into operating (running the business), investing (long-term assets, businesses, some investments) and financing (borrowing, repaying, issuing or buying back shares, dividends).

Three links.

Profit into equity. Opening retained earnings + profit − dividends declared (− anything else the company charges there) = closing retained earnings.
Cash into the balance sheet. Opening cash + operating + investing + financing (+ any exchange-rate effect) = closing cash.
Profit into operating cash. The indirect method starts from profit, adds back expenses that used no cash (such as depreciation), then adjusts for changes in working capital: more stock or more money owed by customers means less cash; more owed to suppliers means more cash.

How an analyst approaches it

Don't start from the client's sum. "Profit minus dividends" isn't how cash moves; write down the three links first.
Tie the figures. Reconcile retained earnings, then cash, to the exact figure. If they don't close, something is missing (here, a buyback charge).
Read each section of the cash flow statement. What came in from operations, what went into investment, what went to lenders and shareholders?
Explain the biggest gap. Why does operating cash differ from profit? Pick the two largest causes, and check every sign.
Answer the question asked, in one sentence, at the top.

Why it matters

Each statement on its own can mislead. Profit can look healthy while cash drains away into stock and unpaid customer bills; cash can look healthy because the company has just borrowed. An analyst reads the three together and asks whether they tell the same story. Every later lesson in this path is a version of that question.

More detail: a new layout for IFRS income statements from 2027

IFRS 18, Presentation and Disclosure in Financial Statements, replaces IAS 1 for annual periods beginning on or after 1 January 2027 (earlier use is allowed). It sorts income and expenses into operating, investing and financing categories (plus income taxes and discontinued operations) and, for most companies, requires two subtotals: operating profit and profit before financing and income taxes. Companies must also explain, in a note, any "management-defined performance measures" (their own adjusted profit figures) that they use in public communications. US companies, which follow US GAAP, are not affected. The ideas in this path don't change; the labels on IFRS statements will.

Worked example

A small shop's year (thousands): sales 500, all on credit; cost of goods sold 300; other expenses paid in cash 120; depreciation 20; so profit is 60 (no tax, to keep it simple). Receivables rose from 40 to 90, inventory from 70 to 80, payables to suppliers from 30 to 35.

Start from profit: 60
Add back depreciation (no cash left this year): +20
Receivables up 50 (sales booked, cash not collected): −50
Inventory up 10 (cash tied up in stock): −10
Payables up 5 (bills not yet paid): +5
Operating cash flow = 25

If the shop also spent 40 on fittings (investing) and paid a dividend of 10 (financing), cash changed by 25 − 40 − 10 = −25: it fell in a profitable year.

Common mistake

Treating profit as cash, or "profit minus dividends" as the change in cash. Cash moves through all three sections of the cash flow statement; profit reaches cash only through the operating section, after non-cash items and working capital.

Key terms

income statement: revenue less expenses for a period, ending in profit (also called the profit and loss account)
cash flow statement: the change in cash for a period, split into operating, investing and financing
accrual accounting: counting revenue when earned and expenses when incurred, not when cash moves
retained earnings: profits kept in the business over the years, part of equity
indirect method: building operating cash flow from profit by adjusting for non-cash items and working-capital changes
working capital: short-term assets such as receivables and inventory, less short-term liabilities such as payables

Practise the key terms

Tap a card to turn it over. 6 cards.

Front	Back
income statement	revenue less expenses for a period, ending in profit (also called the profit and loss account)
cash flow statement	the change in cash for a period, split into operating, investing and financing
accrual accounting	counting revenue when earned and expenses when incurred, not when cash moves
retained earnings	profits kept in the business over the years, part of equity
indirect method	building operating cash flow from profit by adjusting for non-cash items and working-capital changes
working capital	short-term assets such as receivables and inventory, less short-term liabilities such as payables

Task

Write the half-page note for the client, using only the documents above. It should:

reconcile Costco's retained earnings from 22,650 to 28,591;
reconcile its cash from 14,161 to 20,207;
explain in plain words why operating cash (15,817) is so much higher than profit (9,226);
answer the client's worry in one sentence at the top.

My first sentence answers the client's worry directly.
My retained-earnings reconciliation adds up exactly, and names the buyback charge.
My cash reconciliation uses all three sections and the exchange-rate effect, and adds up exactly.
I explained the gap between operating cash and profit with the biggest items, not a list of every line.
I said what the company spent its spare cash on.
Every number in my note comes from the 10-K, with the year end stated.

Model answer

Show the model answer

Costco: how 9.2 billion of profit became 6 billion more cash · Source: Form 10-K, 52 weeks to 30 August 2026
The numbers add up, but not the way the client thinks. Cash rose by a little less than profit minus dividends (6.0 against 6.8 billion), and the two are close only by coincidence: operations brought in 6.6 billion more cash than profit, and Costco spent 9.7 billion on new warehouses, dividends and buybacks.
Profit to retained earnings. 22,650 + 9,226 profit − 2,458 dividends − 827 of share buybacks charged to retained earnings = 28,591.
Cash. 14,161 + 15,817 from operations − 6,378 invested (mainly 6,435 on property and equipment) − 3,355 financing (mainly 2,458 dividends and 848 buybacks) − 38 exchange-rate effect = 20,207, a rise of 6,046.
Why operating cash beat profit by 6.6 billion. Two things. Depreciation (2,674) and other non-cash items such as stock-based pay and lease expense (1,597) reduced profit but used no cash. And suppliers funded more of the stock: accounts payable rose 2,755 while inventories rose 1,153. A business that sells goods before it pays for them gets cash ahead of profit while it grows.

How the expert gets there. They do the two reconciliations first, because they're mechanical and prove the figures tie. Then they spend their words on the one interesting question, the gap between profit and operating cash, and pick the two biggest causes. They check every sign: an increase in inventory is a use of cash, an increase in payables a source.

What a reviewer would flag:

"Cash rose because profit was high": half the story; investing and financing matter as much.
Leaving out the 827 of buybacks in retained earnings, so the reconciliation doesn't close. (Costco charges part of the cost of buybacks to retained earnings and the rest to paid-in capital; the cash flow statement shows 848 paid in total.)
Reading "Merchandise inventories (1,153)" as stock falling. The bracket means cash went out because stock went up.
Calling the payables effect "free money": it's a timing benefit that reverses if growth slows.

Practice

Work it through

Warm-up. A company starts the year with cash of 800. Profit 300; depreciation 90; receivables up 120; inventory down 40; payables down 30. It spends 250 on equipment, borrows 100 and pays dividends of 60.

Operating cash flow
Investing cash flow
Financing cash flow
Closing cash

Transfer: a different company, a different worry. A client emails: "Lowe's earned 7.7 billion in the year to 2 February 2024, yet its cash fell by more than 400 million. Is something wrong?" From the cash flow statement in Lowe's Form 10-K for the year to 30 January 2026 (the 2023 column; millions): net earnings 7,726; operating activities 8,140; investing activities (1,901), of which capital expenditures (1,964); financing activities (6,666), including net change in commercial paper (499), debt issued 2,983, debt repaid (601), dividends (2,531) and share buybacks (6,138); cash 1,348 → 921. Open the 10-K for anything else you need. In three sentences: is this a warning sign, and what would change your mind?

I said whether the operations themselves produced cash.
I compared what was paid to shareholders with the cash left after investment.
I said how the gap was funded, with the figures.
I gave a verdict and what would change it.

A model answer

Not an operating problem, but a deliberate choice worth watching: Lowe's paid shareholders more than its business produced in spare cash, and borrowed the difference. Operating cash (8,140) exceeded net earnings, and after 1,964 of capital spending about 6.2 billion was left; but dividends and buybacks took 8.7 billion, and net new borrowing (2,983 issued, less 601 repaid and 499 of commercial paper) of about 1.9 billion filled most of the gap, and a 427 million fall in cash covered most of the rest. Years of this, and the far larger buybacks of fiscal 2021–22, are why Lowe's shows a shareholders' deficit. What would change my mind: operating cash falling while payouts stay high, or debt rising faster than the cash the business produces to service it.

How the expert gets there: they compare payouts with cash after investment, not with profit, and then look at financing to see what closed the gap.

What a reviewer would flag: "cash fell, so the business is weak" (operations were strong); comparing buybacks with net earnings instead of free cash flow; leaving out the borrowing.

In short

Income statement: profit over a period. Balance sheet: own and owe on a date. Cash flow statement: where the cash went.
Profit less dividends (and anything else charged there) moves retained earnings.
Opening cash plus the three sections (and exchange effects) gives closing cash.
Non-cash costs and working capital explain why operating cash differs from profit.
Follow the cash: ask what happened in each section before judging.

Check yourself

Answer in your head first, then open the answer. Nothing is saved.

Which statement covers a single date rather than a period?
Show answer
The balance sheet.
A company's profit rose but its operating cash flow fell. What two things would you look at first?
Show answer
Working capital (did receivables or inventory grow much faster than sales, or payables shrink?) and whether profit included gains that brought in no cash.
Why can cash rise by more than profit minus dividends?
Show answer
Because operating cash can exceed profit (non-cash costs, suppliers funding stock), and investing and other financing flows may be smaller than that surplus.