1. What you will learn
By the end of this lesson you will be able to describe how the three financial statements link to one another, explain why depreciation reduces profit but not cash, trace a period from opening cash to closing cash through operating, investing and financing flows, and build the two checks that tell you whether a model is internally consistent. You will also understand why plugging cash to force a balance is the most damaging habit in financial modelling. This is education about how accounts work and is not advice about any company or security.
2. The idea explained
A company's accounts are three views of the same period. The profit and loss account measures performance under accrual rules, recognising revenue when it is earned and costs when they are incurred, regardless of when money moves. The balance sheet is a photograph at one instant, listing what the company controls and who has a claim on it, and it must balance because every asset is funded by either a liability or equity. The cash flow statement reconciles the two by showing where cash actually went.
Depreciation is the clearest illustration of why all three are needed. When a company buys a machine, cash leaves at once, but the profit and loss account does not recognise the whole cost immediately. Instead the cost is spread over the asset's useful life as depreciation. So profit in later years is reduced by an expense that involves no cash movement at all, which is why the indirect cash flow statement starts from profit and adds depreciation back. Meanwhile the original purchase appears as capital expenditure under investing activities in the year the money actually left.
Working capital is the second bridge. If receivables rise, the company has recognised revenue but not collected it, so cash is lower than profit suggests. If inventory rises, cash has been converted into goods sitting in a warehouse. If payables rise, suppliers are financing the business and cash is higher than profit suggests.
The structure of a model follows from this. The profit and loss account feeds the cash flow statement through the indirect method. Closing cash from the cash flow statement becomes the cash line on the balance sheet, and retained earnings grow by profit less dividends.
Two checks then tell you whether everything holds together. First, the balance sheet must balance in every period, not just the first. Second, opening cash plus the net change from the three cash flow sections must equal closing cash. If either fails, something is genuinely wrong, and the temptation is to insert a plug into cash to make the numbers agree. That plug hides the error rather than fixing it, and every number downstream of it becomes unreliable.
3. The market, the regulator and the rulebook
Financial statements of Indian companies are prepared under the Companies Act and the accounting standards notified under it, and listed companies must publish periodic results and annual reports under the disclosure requirements administered by the Securities and Exchange Board of India, the statutory securities regulator constituted by an Act of Parliament.
The notes to the accounts matter as much as the statements themselves. Depreciation policies, useful lives, revenue recognition policies, related-party transactions, contingent liabilities and the auditor's report all change how the headline figures should be read,.
Where a model needs a tax rate, a duty or a statutory charge, do not state one from memory. Use an assumed rate, label it as an assumption, and cite where the current statutory position is published.
Worked example
4. Worked example
All figures are invented and in rupees. A hypothetical company opens the year with fifty of cash.
Start with the profit and loss account. Revenue is one thousand and operating costs before depreciation are eight hundred, so earnings before interest, tax, depreciation and amortisation are two hundred. Depreciation is fifty, giving operating profit of one hundred and fifty. Interest is twenty, giving profit before tax of one hundred and thirty. At an assumed tax rate of twenty-five per cent, chosen purely for arithmetic and not as a statement of any current rate, tax is thirty-two point five and profit after tax is ninety-seven point five.
Now operating cash flow by the indirect method. Start with profit after tax of ninety-seven point five, add back depreciation of fifty, and subtract a working capital increase of thirty. Operating cash flow is one hundred and seventeen point five.
Now investing and financing. Capital expenditure is sixty, an outflow. Net borrowing is ten, an inflow. The net change in cash is one hundred and seventeen point five, less sixty, plus ten, which is sixty-seven point five. Closing cash is fifty plus sixty-seven point five, which is one hundred and seventeen point five.
Now the balance check. Assets rose by sixty-seven point five of cash, plus thirty of working capital, plus ten of net fixed assets, since capital expenditure of sixty exceeded depreciation of fifty. Total assets rose by one hundred and seven point five. On the other side, debt rose by ten and retained earnings by ninety-seven point five, which is also one hundred and seven point five. The model balances.
Now the sensitivity in the simplest form. Hold everything else and raise capital expenditure to ninety. The net change in cash becomes one hundred and seventeen point five, less ninety, plus ten, which is thirty-seven point five, so closing cash falls to eighty-seven point five. A model that still reports one hundred and seventeen point five has an integration error, not a rounding difference.
5. Common mistakes and how to fix them
The first mistake is deriving cash from profit alone. Always route profit through the full cash flow statement, because investment and financing flows are not in the profit and loss account.
The second is getting the working capital sign wrong. Write out in words whether the item is a use or a source of cash before applying the sign.
The third is burying assumptions inside formulas. Keep every assumption in a separate, clearly labelled input area so a reviewer can change one number and see the effect.
The fourth is plugging cash to force a balance. Treat a failed check as a bug to be found, never as a cell to be overwritten.
The fifth is believing a model that balances is therefore correct. A model is a calculator, not a forecast, past performance does not indicate future results, and a SEBI-registered investment adviser is the person to consult about an individual's own money.
Key takeaways
6. Board summary
The profit and loss account measures performance on accruals, the balance sheet is an instant, and the cash flow statement reconciles them. Depreciation reduces profit without moving cash and is added back, while capital expenditure is a cash outflow in the year it occurs. Rising receivables and inventory consume cash; rising payables supply it. Closing cash equals opening cash plus operating, investing and financing flows, and the balance sheet must balance every period. A plug inserted into cash hides an error and makes everything downstream unreliable.
Check your understanding
7. Practice and self-check
One. Opening cash is fifty, operating cash flow eighty, capital expenditure sixty and net borrowing ten. Closing cash? Eighty.
Two. Capital expenditure rises to ninety with all else unchanged. Closing cash? Fifty.
Three. Profit after tax is one hundred, depreciation twenty, receivables rise thirty and inventory rises ten. Operating cash flow? Eighty.
Four. Payables also rise fifteen. Revised operating cash flow? Ninety-five.
Five. Why is a payables increase a source of cash? Because suppliers have not yet been paid, so the business is financing itself with their money.
Six. Capital expenditure is seventy and depreciation forty. What happens to net fixed assets? They rise by thirty.
Seven. In that same year, profit after tax is sixty and no dividend is paid. What happens to retained earnings? They rise by sixty.
Eight. A model balances in year one but not year three. What is the likely cause? An error in a schedule that only takes effect later, such as debt repayment or depreciation on new assets.
Nine. Where do you read a company's depreciation policy? In the notes to its published annual report, on its own or the exchange's website, cited with a date.