02.6 · How the three statements link¶

Why this matters: the income statement, balance sheet and cash-flow statement are not three documents but one double-entry system seen from three angles. If you can push a transaction through all three and tie two balance sheets to a cash-flow statement, you can build a model, audit someone else's, and notice when a company's numbers do not add up.

Learning objectives — after this lesson you can:

State the core linkages — profit to equity, D&A and capex to fixed assets, working capital, debt and interest, leases, tax, cash — and draw them as a flow diagram.
Post any transaction through the P&L, balance sheet and cash-flow statement at once, keeping Assets = Liabilities + Equity after every step.
Rebuild Kaveri's FY26 operating, investing and financing cash flows from its P&L and two balance sheets (the "tie-out drill"), stating every assumption you make.
Answer "what happens to all three statements if…" questions, including the tax subtleties.
Diagnose why a model does not balance from the size and pattern of the error.

Prerequisites: 02.1 The accounting equation & double entry, 02.3 The income statement, 02.4 The balance sheet, 02.5 The cash-flow statement · Time: ~120 min

1. One system, three views¶

Think of a company as a set of accounts (bank, receivables, inventory, machines, loans, equity…). The balance sheet lists the balances at the start and end of the year. Everything that happened in between is a flow, and the other two statements are two different summaries of those flows:

The income statement summarises the flows that change equity through operations — revenue and expenses. Its bottom line (profit after tax) is the main reason retained earnings change.
The cash-flow statement summarises the flows that change one particular asset, cash — sorted into operating, investing and financing.

So each statement "explains" a change in a balance-sheet line: the P&L explains most of the change in retained earnings, and the CFS explains all of the change in cash. The two are connected because almost every P&L item eventually becomes cash, and the timing difference between the two sits on the balance sheet as working capital, fixed assets, provisions and deferred tax.

A three-line derivation makes this precise. Split assets into cash and non-cash assets:

\[\text{Cash} + \text{Non-cash assets} = \text{Liabilities} + \text{Equity}\]

Take the change over the year:

\[\Delta\text{Cash} = \Delta\text{Liabilities} + \Delta\text{Equity} - \Delta\text{Non-cash assets}\]

That is the whole cash-flow statement. Every line of it is the change in some other balance-sheet line (with the sign flipped for assets), re-sorted into three buckets, with the change in retained earnings replaced by its detailed explanation — profit, adjusted for its non-cash items, less dividends. The CFS contains no information that is not in the two balance sheets plus the P&L and a few notes. Which means you can rebuild it (§4), and a model that gets it wrong will not balance (§6).

flowchart TB
  subgraph PL[Income statement FY26]
    REV[Revenue 1,318.0] --> EBITDA[EBITDA 181.9]
    EBITDA -->|less D and A 47.8| EBIT[EBIT 134.1]
    EBIT -->|+ other income 3.9<br/>− finance costs 17.0| PBT[PBT 121.0]
    PBT -->|− tax 30.5| PAT[PAT 90.5]
  end
  subgraph BS[Balance sheet 31-Mar-2026]
    FA[PPE, CWIP, ROU, intangibles]
    WC[Inventories, receivables,<br/>payables, other WC]
    DEBT[Borrowings and lease liabilities]
    EQ[Other equity]
    DTL[Deferred tax liability]
    CASH[Cash 32.5]
  end
  subgraph CF[Cash-flow statement FY26]
    CFO[CFO 65.1]
    CFI[CFI −33.1]
    CFF[CFF −27.5]
  end
  PAT -->|+ PAT, − dividends, + ESOP| EQ
  PBT --> CFO
  EBITDA -.->|D and A reduces| FA
  WC -->|Δ working capital −89.7| CFO
  CFI -->|capex 52.0 adds to| FA
  CFF -->|net borrowing +18.0,<br/>interest, leases, dividends| DEBT
  PBT -.->|deferred tax 1.0| DTL
  CFO --> CASH
  CFI --> CASH
  CFF --> CASH

2. The linkages, one at a time — Kaveri FY25 → FY26¶

Here is every line of Kaveri's balance sheet, the change during FY26, and where that change came from. This is the single most useful table in the module: once you can fill it in for any company, you understand its accounts. (₹ Cr; source: the Kaveri running example.)

Balance-sheet line	FY25	FY26	Change	Explained by	In the P&L	In the CFS
PP&E (net block) + CWIP	488.9	497.3	8.4	+ capex 48.0 − depreciation 39.6	Depreciation 39.6	Capex (48.0) in CFI; depreciation added back in CFO
Right-of-use assets	15.2	16.5	1.3	+ new leases 6.0 − amortisation 4.7	ROU amortisation 4.7	Amortisation added back in CFO; new leases non-cash
Intangible assets	7.5	8.0	0.5	+ purchases 4.0 − amortisation 3.5	Amortisation 3.5	Purchase (4.0) in CFI; amortisation added back
Inventories	161.3	188.1	26.8	Bought more than consumed	Material cost includes Δ inventory	(26.8) in CFO
Trade receivables	269.7	346.7	77.0	Billed more than collected	Revenue 1,318.0	(77.0) in CFO
Other current assets	35.2	39.5	4.3	Advances, prepaid, GST credit up	—	(4.3) in CFO
Current investments	30.0	15.0	(15.0)	Liquid funds sold	Treasury income 3.9 (in other income)	+15.0 in CFI
Cash & cash equivalents	28.0	32.5	4.5	The net result of everything	—	Net change +4.5
Total assets	1,035.8	1,143.6	107.8
Share capital	30.0	30.0	0.0	No issue or buyback	—	—
Other equity	607.2	676.1	68.9	+ PAT 90.5 − dividends 24.0 + ESOP 2.4	PAT 90.5; ESOP inside employee cost	Dividends (24.0) in CFF; ESOP added back in CFO
Borrowings — non-current	112.0	92.0	(20.0)	Term-loan repayment	Interest 15.6 on all borrowings	(20.0) in CFF; interest paid (15.6) in CFF
Borrowings — current	58.0	96.0	38.0	Working-capital drawdown	(as above)	+38.0 in CFF
Lease liabilities	16.7	18.2	1.5	+ new leases 6.0 + interest 1.4 − payments 5.9	Lease interest 1.4	Payments (5.9) in CFF
Trade payables	132.3	143.4	11.1	Suppliers' credit up	—	+11.1 in CFO
Other current liabilities & provisions	58.6	65.9	7.3	Statutory dues, advances, accruals	—	+7.3 in CFO
Deferred tax liability	21.0	22.0	1.0	Deferred tax charge	Deferred tax 1.0	None (non-cash); current tax 29.5 paid in CFO
Total equity & liabilities	1,035.8	1,143.6	107.8

Read the table as a list of linkages you must never break:

Profit → equity. PAT flows into retained earnings; dividends come out; other equity movements (ESOP reserve, OCI, share issues) are shown in the statement of changes in equity. Check: 607.2 + 90.5 − 24.0 + 2.4 = 676.1.
D&A → fixed assets; capex → fixed assets. Opening net fixed assets + capex − D&A − book value of disposals = closing. Check: 488.9 + 48.0 − 39.6 = 497.3.
Working capital → CFO. Every operating asset or liability that changes shows up, with the sign rule of 02.5, in CFO.
Debt and interest. The P&L carries the interest expense; the balance sheet carries the principal (and any interest accrued but unpaid); CFF carries interest paid and principal drawn or repaid.
Leases. New leases add to both ROU assets and lease liabilities without cash; amortisation and lease interest hit the P&L; payments hit CFF.
Tax. Tax expense (30.5) = current tax (29.5, paid in cash here because no tax payable or refund balance moved) plus deferred tax (1.0, which increased the deferred tax liability and never touched cash).
Cash. CFO + CFI + CFF = change in balance-sheet cash. Check: 65.1 − 33.1 − 27.5 = 4.5 = 32.5 − 28.0.

3. Worked example 1 — twelve transactions through all three statements¶

Kaveri is too big to follow transaction by transaction, so we use a small fictional business: Noyyal Rewinding Works Pvt Ltd, a motor-rewinding and pump-repair shop in Tiruppur. Amounts are in ₹ lakh (1 lakh = 100,000); the year is FY26 (1-Apr-2025 to 31-Mar-2026); tax is a flat 25% for simplicity. The opening balance sheet:

Noyyal, 1-Apr-2025, ₹ lakh
Cash	10.0	Trade payables	10.0
Trade receivables	12.0	Term loan	25.0
Inventory (copper wire, bearings, spares)	15.0	Share capital + securities premium (10.0 + 5.0)	15.0
Equipment: gross 60.0 − acc. dep. 12.0	48.0	Retained earnings	35.0
Total assets	85.0	Total liabilities & equity	85.0

The twelve transactions of the year, and what each one does to each statement:

#	Transaction	P&L	Balance sheet	Cash-flow statement
T1	Issue 20,000 shares of ₹10 face value at ₹100	—	Cash +20.0; share capital +2.0; securities premium +18.0	CFF +20.0
T2	Buy a winding machine for 30.0: pay 24.0 now, 6.0 due in 60 days	—	Equipment +30.0; cash −24.0; capital creditors +6.0	CFI −24.0 (the 6.0 is non-cash until paid)
T3	Buy materials on credit, 40.0	—	Inventory +40.0; trade payables +40.0	—
T4	Sales of 90.0 (60.0 cash, 30.0 on credit); materials consumed 38.0	Revenue 90.0; cost of materials 38.0	Cash +60.0; receivables +30.0; inventory −38.0; retained earnings +52.0	CFO +60.0
T5	Collect 25.0 from customers	—	Cash +25.0; receivables −25.0	CFO +25.0
T6	Pay suppliers 35.0	—	Cash −35.0; trade payables −35.0	CFO −35.0
T7	Employee cost 20.0: 18.0 paid, 2.0 year-end bonus accrued	Employee cost 20.0	Cash −18.0; accrued liabilities +2.0; retained earnings −20.0	CFO −18.0
T8	Pay 8.0 of rent and power, of which 1.0 is April's rent paid in advance	Other expenses 7.0	Cash −8.0; prepaid expenses +1.0; retained earnings −7.0	CFO −8.0
T9	Depreciation for the year, 9.0	Depreciation 9.0	Accumulated depreciation +9.0 (net equipment −9.0); retained earnings −9.0	— (non-cash)
T10	Loan instalment 7.0 = interest 2.0 + principal 5.0	Finance cost 2.0	Cash −7.0; term loan −5.0; retained earnings −2.0	CFF −5.0 (principal), CFF −2.0 (interest, Ind AS 7)
T11	Tax at 25% on PBT of 14.0 = 3.5; advance tax paid 2.5	Tax 3.5	Cash −2.5; tax payable +1.0; retained earnings −3.5	CFO −2.5
T12	Pay a dividend of 3.0	— (not an expense)	Cash −3.0; retained earnings −3.0	CFF −3.0

The running balance sheet. After every transaction the two totals must agree. (Retained earnings include the current year's P&L as it accrues; "Accruals & tax" = accrued bonus + tax payable.)

After	Cash	Receivables	Inventory	Prepaid	Net equip.	Total assets	Payables	Capital creditors	Accruals & tax	Term loan	Share cap. + premium	Retained earnings	Total L + E
Opening	10.0	12.0	15.0	0.0	48.0	85.0	10.0	0.0	0.0	25.0	15.0	35.0	85.0
T1	30.0	12.0	15.0	0.0	48.0	105.0	10.0	0.0	0.0	25.0	35.0	35.0	105.0
T2	6.0	12.0	15.0	0.0	78.0	111.0	10.0	6.0	0.0	25.0	35.0	35.0	111.0
T3	6.0	12.0	55.0	0.0	78.0	151.0	50.0	6.0	0.0	25.0	35.0	35.0	151.0
T4	66.0	42.0	17.0	0.0	78.0	203.0	50.0	6.0	0.0	25.0	35.0	87.0	203.0
T5	91.0	17.0	17.0	0.0	78.0	203.0	50.0	6.0	0.0	25.0	35.0	87.0	203.0
T6	56.0	17.0	17.0	0.0	78.0	168.0	15.0	6.0	0.0	25.0	35.0	87.0	168.0
T7	38.0	17.0	17.0	0.0	78.0	150.0	15.0	6.0	2.0	25.0	35.0	67.0	150.0
T8	30.0	17.0	17.0	1.0	78.0	143.0	15.0	6.0	2.0	25.0	35.0	60.0	143.0
T9	30.0	17.0	17.0	1.0	69.0	134.0	15.0	6.0	2.0	25.0	35.0	51.0	134.0
T10	23.0	17.0	17.0	1.0	69.0	127.0	15.0	6.0	2.0	20.0	35.0	49.0	127.0
T11	20.5	17.0	17.0	1.0	69.0	124.5	15.0	6.0	3.0	20.0	35.0	45.5	124.5
T12	17.5	17.0	17.0	1.0	69.0	121.5	15.0	6.0	3.0	20.0	35.0	42.5	121.5

The three finished statements.

Income statement, FY26 (₹ lakh): revenue 90.0 − materials 38.0 − employee cost 20.0 − other expenses 7.0 = EBITDA 25.0; − depreciation 9.0 = EBIT 16.0; − finance cost 2.0 = PBT 14.0; − tax 3.5 = PAT 10.5.

Retained earnings: 35.0 + PAT 10.5 − dividend 3.0 = 42.5 ✓ (matches the last row).

Fixed assets: 48.0 + purchases 30.0 − depreciation 9.0 = 69.0 ✓.

Cash-flow statement, indirect method (Ind AS 7 presentation):

Noyyal FY26, ₹ lakh	Amount	Source
Profit before tax	14.0	P&L
Add: depreciation	9.0	T9
Add: finance cost (interest paid goes to CFF)	2.0	T10
Operating profit before working-capital changes	25.0	= EBITDA, as expected
(Increase) in inventory	(2.0)	15.0 → 17.0
(Increase) in receivables	(5.0)	12.0 → 17.0
(Increase) in prepaid expenses	(1.0)	0.0 → 1.0
Increase in trade payables	5.0	10.0 → 15.0
Increase in accrued bonus	2.0	0.0 → 2.0
Income tax paid	(2.5)	Tax expense 3.5 − increase in tax payable 1.0
Cash flow from operations	21.5
Purchase of equipment	(24.0)	30.0 bought − 6.0 still owed (capital creditors are not working capital)
Cash flow from investing	(24.0)
Issue of shares	20.0	T1
Repayment of term loan	(5.0)	T10
Interest paid	(2.0)	T10
Dividend paid	(3.0)	T12
Cash flow from financing	10.0
Net change in cash	7.5	= 17.5 − 10.0 ✓

Direct-method check: receipts from customers 60.0 + 25.0 = 85.0; paid to suppliers 35.0, employees 18.0, rent and power 8.0, tax 2.5; CFO = 85.0 − 35.0 − 18.0 − 8.0 − 2.5 = 21.5 ✓.

What the example teaches.

Three different "bottom lines". PAT 10.5, CFO 21.5, change in cash 7.5. Each answers a different question (was the year profitable? did operations generate cash? did the bank balance go up?).
Accruals move profit and cash apart in both directions. The bonus accrual (T7) cut profit by 2.0 without cash; the prepaid rent (T8) cut cash by 1.0 without profit; credit sales (T4) booked profit without cash.
Non-cash investing. The 6.0 owed for the machine sits in "capital creditors", which is a financing-like liability of the investing activity, not trade payables. Put it in working capital by mistake and you overstate CFO by 6.0 and capex by 6.0 at the same time — cash still ties, so the error is invisible to the balance check. That is exactly the kind of misclassification 09.4 warns about.
Tax paid ≠ tax expense. 3.5 expensed, 2.5 paid; the 1.0 difference sits in tax payable.
Dividends are not expenses. They reduce equity and cash, never profit.

Trader's lens

The balance check is the accountant's P&L explain. On a desk, every change in a position's value must be attributed to trades (cash moving) or marks (P&L); anything left over is "unexplained P&L" and means a booking error. In a three-statement model, the balance sheet is the position report, the P&L is the marks, the CFS is the trade blotter, and "Assets − (Liabilities + Equity)" is the unexplained residual. It must be exactly zero, and — like unexplained P&L — the size and persistence of a non-zero residual usually tell you which trade was mis-booked (§6).

4. Worked example 2 — the tie-out drill: rebuild Kaveri FY26 cash flows¶

Pretend Kaveri's cash-flow statement is missing. Using only the FY26 P&L, the FY25 and FY26 balance sheets and two facts from the notes, rebuild CFO, CFI and CFF. This is how you check a company's CFS, how you build historical cash flows when a data vendor garbles them, and how every forecast model works.

Facts from the notes. (a) Dividend paid in FY26: ₹4.0 per share on 6.00 Cr shares = ₹24.0 Cr. (b) No PP&E was sold in FY26. We also assume, as the reference page states, that other income is entirely treasury income received in cash, and that there are no interest-accrued or tax-payable balances.

Step 1 — CFO, starting from PAT (the analyst's route).

Step	₹ Cr	Where it comes from
PAT	90.5	P&L
+ Depreciation & amortisation	47.8	P&L (39.6 + 4.7 + 3.5)
+ Deferred tax (non-cash part of tax)	1.0	Δ deferred tax liability 21.0 → 22.0
+ Share-based payment (non-cash)	2.4	Δ other equity 68.9 − PAT 90.5 + dividends 24.0
+ Finance costs (belong in CFF)	17.0	P&L
− Treasury income (belongs in CFI)	(3.9)	P&L
− Increase in inventories	(26.8)	Balance sheets
− Increase in trade receivables	(77.0)	Balance sheets
− Increase in other current assets	(4.3)	Balance sheets
+ Increase in trade payables	11.1	Balance sheets
+ Increase in other current liabilities	7.3	Balance sheets
CFO	65.1	✓ matches the reported figure

Kaveri's own statement starts from PBT (121.0) and deducts taxes paid (29.5); we started from PAT, which is after the full tax expense (30.5), and added back the non-cash deferred portion (1.0). The two routes must agree: PAT + tax expense − tax paid = 90.5 + 30.5 − 29.5 = 91.5 = PAT + deferred tax. Note also that the ESOP charge was derived from the equity roll-forward — you did not need to be told it.

Step 2 — CFI.

Step	₹ Cr	Derivation
Capex on PP&E incl. CWIP	(48.0)	Δ(net block + CWIP) + depreciation + book value of disposals = (497.3 − 488.9) + 39.6 + 0
Purchase of intangibles	(4.0)	Δ intangibles + amortisation = (8.0 − 7.5) + 3.5
Sale of current investments	15.0	30.0 → 15.0
Treasury income received	3.9	= other income (assumed received in cash)
CFI	(33.1)	✓

Step 3 — CFF.

Step	₹ Cr	Derivation
Net term-loan repayment	(20.0)	112.0 → 92.0
Net working-capital borrowing	38.0	58.0 → 96.0
Interest paid on borrowings	(15.6)	= finance cost on borrowings (no interest-accrued balance)
Lease payments	(5.9)	New leases = 16.5 − 15.2 + 4.7 = 6.0 (from the ROU roll-forward); payments = 16.7 + 6.0 + 1.4 − 18.2 = 5.9
Dividends paid	(24.0)	Note (a); cross-check: PAT 90.5 + ESOP 2.4 − Δ other equity 68.9 = 24.0
CFF	(27.5)	✓

Step 4 — the tie. 65.1 − 33.1 − 27.5 = 4.5 = 32.5 − 28.0 ✓. Every number in Kaveri's CFS has been rebuilt from the other statements.

# The tie-out drill in code (runs offline on the course data)
import pandas as pd
k = pd.read_csv("tools/data/kaveri_pumps_annual.csv", index_col="line_item")  # = tools/fi/data.py::load_kaveri()
c, p = k["FY26"], k["FY25"]
dividends = 4.0 * 6.0                                   # DPS paid x shares, from the notes
sbc = (c.other_equity - p.other_equity) - c.pat + dividends
d_wc = -(c.inventory - p.inventory) - (c.receivables - p.receivables) - (c.oca - p.oca) \
       + (c.payables - p.payables) + (c.ocl - p.ocl)
cfo = c.pat + c.da + (c.dtl - p.dtl) + sbc + c.fin_cost - c.other_income + d_wc
capex = (c.net_block + c.cwip) - (p.net_block + p.cwip) + c.dep_ppe   # no disposals in FY26
intang = (c.intangibles - p.intangibles) + c.int_amort
cfi = -capex - intang - (c.cur_inv - p.cur_inv) + c.other_income
new_leases = c.rou - p.rou + c.rou_amort
lease_pay = p.lease_liab + new_leases + c.lease_int - c.lease_liab
cff = (c.lt_debt - p.lt_debt) + (c.st_debt - p.st_debt) - c.debt_int - lease_pay - dividends
print(round(cfo, 1), round(cfi, 1), round(cff, 1), round(cfo + cfi + cff, 1), round(c.cash - p.cash, 1))
# -> 65.1 -33.1 -27.5 4.5 4.5

Why real tie-outs rarely close to the rupee. On a real company the rebuilt CFS usually differs from the reported one, and the differences are themselves information. The usual reasons:

Acquisitions and disposals of subsidiaries. The acquired company's receivables, inventory and debt arrive on the balance sheet without passing through working capital; the CFS shows a single "acquisition, net of cash" line.
Foreign-currency translation. Overseas subsidiaries' balances change with the exchange rate, not with cash.
Non-cash items hiding in "other". Provisions, write-offs, fair-value changes, unrealised FX.
Capital creditors and capital advances. Capex accrued but unpaid (or paid in advance) sits in other liabilities/assets; mix them into working capital and CFO and capex both move.
Capitalised interest. Interest paid exceeds the P&L finance cost when part of it was added to CWIP.
Reclassifications and restatements. Last year's balance sheet as reported last year may differ from the comparative in this year's report. Always use the comparative column from the current report.

A small, explained difference is normal. A large, unexplained one — especially one that consistently flatters CFO — is a question for the company (09.4).

5. "What happens to the three statements if…?"¶

These chains are the fastest way to test your understanding (and a staple of analyst interviews). Assume a 25% tax rate.

(a) Depreciation is ₹10 higher — and it is tax-deductible. P&L: EBIT −10, tax −2.5, PAT −7.5. CFS: PAT −7.5, add back depreciation +10, CFO +2.5 (the tax saved). Balance sheet: net PP&E −10, cash +2.5 → assets −7.5; retained earnings −7.5 ✓.

(b) Book depreciation is ₹10 higher but tax depreciation is unchanged (the usual case when a company shortens a book useful life — 02.7). P&L: PBT −10; current tax unchanged; deferred tax −2.5 (a credit); PAT −7.5. CFS: CFO unchanged (PAT −7.5 + depreciation +10 − deferred-tax credit 2.5 = 0). Balance sheet: PP&E −10; deferred tax liability −2.5; equity −7.5 → assets −10 = liabilities −2.5 + equity −7.5 ✓. Accounting choices move profit, not cash.

(c) An inventory write-down of ₹20, tax-deductible. P&L: PAT −15. CFS: PAT −15; inventory fell by 20, which the indirect method records as a +20 working-capital release; CFO +5 (tax saved). Balance sheet: inventory −20, cash +5, equity −15 ✓.

(d) A customer pays a ₹5 advance for next year's order. P&L: nothing (revenue is not yet earned — 02.2). Balance sheet: cash +5; contract liability (other current liabilities) +5. CFS: CFO +5, via the increase in other current liabilities.

(e) The company borrows ₹100 on 31 March and buys a machine with it the same day. P&L: nothing this year. Balance sheet: PP&E +100, borrowings +100. CFS: CFI −100, CFF +100, net 0. Next year: depreciation and interest start.

(f) A state agency pays Kaveri ₹50 Cr of overdue receivables on 1 April instead of 31 March. FY26 P&L: identical. FY26 balance sheet: receivables ₹50 Cr higher and cash ₹50 Cr lower (or working-capital debt ₹50 Cr higher). FY26 CFO: ₹50 Cr lower. One day's timing moves CFO/PAT from 127% to 72% — which is why you judge cash conversion over several years, and why year-end collection drives are the oldest window-dressing trick there is.

(For (f): (65.1 + 50) / 90.5 = 127%; 65.1 / 90.5 = 72%.)

6. What breaks when a model doesn't balance¶

A three-statement model is built so that it cannot balance unless every linkage is right: all balance-sheet lines except cash are driven by schedules (fixed assets, working capital, debt, equity), the CFS is computed from those lines, and closing cash = opening cash + CFS. Then the balance check — total assets minus total liabilities and equity — must be zero in every year. (Many models instead make a revolving credit line the plug when cash would go negative; the principle is the same.)

When it is not zero, the error is almost always one of a handful of broken links. The size and pattern of the imbalance point to the culprit:

Symptom	Likely cause	Kaveri FY26 illustration
Imbalance equals one line item exactly	That item is in one statement but not the other (e.g., added back in CFO but not recorded in equity)	Forget to add back the ₹2.4 Cr ESOP charge in CFO while crediting equity → cash too low, assets short by 2.4
Imbalance equals twice a line item	Sign error on that item	Record the receivables increase as +77.0 instead of (77.0) → assets over by 154.0
Liabilities + equity exceed assets by the dividend	Dividend deducted from cash (CFF) but not from retained earnings — or vice versa	L + E over by 24.0
Imbalance equals capex	Capex deducted from cash but not added to PP&E	Assets short by 48.0
Imbalance equals depreciation, growing every year	D&A added back in CFO and charged in P&L, but not deducted from PP&E	Assets over by 39.6 in FY26, more each year
Imbalance zero in year 1, then growing	A roll-forward uses the wrong opening balance (e.g., opening debt ≠ last year's closing)	—
Imbalance in the first forecast year only	Opening balance sheet doesn't balance, or historical cash ≠ model cash	—
Model balances but cash is implausible	Classification error that nets out (capital creditors in working capital; interest in two places)	See the Noyyal capital-creditors point in §3
Numbers change on every recalculation	Circular reference (interest on average debt ↔ debt depends on cash ↔ cash depends on interest)	—

A debugging routine that works:

Find the first year with a non-zero check. Everything before it is fine.
Note the size of the imbalance. Search the model for a line item equal to it, or to half of it (sign error).
Check whether it is constant or growing across years. Constant → a one-off or opening-balance problem. Growing by a steady amount → a recurring flow (D&A, a working-capital item, a dividend) missing from one statement.
Check the cash tie separately: does closing cash on the CFS equal cash on the balance sheet? If yes, the error is in a non-cash line's roll-forward; if no, it is in the CFS.
Walk the linkage table of §2 line by line: for each balance-sheet line, is the change explained by exactly one CFS line (or a P&L line plus a CFS line)?
Only then look for circularity and rounding.

Circularity. Interest expense depends on debt; debt (or a revolver) depends on cash; cash depends on profit, which depends on interest. Excel users switch on iterative calculation; the course's Python engine, tools/fi/model.py::project, avoids the loop by charging interest on opening debt, and returns a checks frame with the balance and cash checks for every projected year. 10.4 turns this section into a full model-review checklist.

7. The three-statement model, in one picture¶

Everything in this lesson runs backwards when you forecast. You choose drivers, and the linkages generate the statements:

flowchart LR
  D[Drivers<br/>growth, margins, days,<br/>capex %, tax, payout] --> IS[Income statement<br/>revenue → EBITDA → PAT]
  D --> S[Schedules<br/>fixed assets, working capital,<br/>debt, equity]
  IS -->|PAT, D and A| S
  S --> BS[Balance sheet<br/>all lines except cash]
  IS --> CF[Cash-flow statement]
  S -->|Δ each line| CF
  CF -->|closing cash| BS
  BS -->|opening debt and cash| INT[Interest and treasury income]
  INT --> IS
  BS --> CHK{Assets = L + E?}

10.3 builds these schedules for Kaveri FY27–FY29 consistent with the reference valuation, and 10.5 implements the whole thing in Python.

India notes

Start point. Indian cash-flow statements under Ind AS 7 typically start from profit before tax and deduct income taxes paid; many global (IFRS) statements start from profit after tax, and IFRS 18 / Ind AS 118 will move the starting point to operating profit (for India, proposed from FY28 — see 02.5). The tie-out logic is identical; only the first few lines move.
Statement of changes in equity. Ind AS requires it as a primary statement. Use it to get dividends, ESOP reserves, OCI and share issues directly rather than deriving them as we did in §4.
Tax payable is usually small. Indian companies pay advance tax in instalments during the year, so current tax and tax paid are close; big gaps come from refunds, disputes and prior-year assessments.
Classification is fixed for non-financial companies. Interest paid sits in CFF and interest received in CFI (Ind AS 7), so Indian CFO is "pre-interest" — keep that in mind when you compare with US or IFRS peers.
Standalone vs consolidated. Tie out the set you are analysing; mixing a consolidated P&L with a standalone balance sheet is the most common reason an Indian tie-out fails. Aggregators (Screener, etc.) sometimes reclassify items such as other income; tie out against the annual report.

Common mistakes

Treating dividends as an expense, or forgetting to deduct them from retained earnings.
Using tax expense as tax paid. Deferred tax is not cash; tax payable moves the timing further.
Putting capital creditors or capital advances into working capital. It shifts cash between CFO and CFI.
Using the prior year's originally reported balance sheet rather than the comparative restated in the current report.
Forgetting non-cash additions — new leases, assets acquired in business combinations, share-settled payments — when rolling forward fixed assets or debt.
Fixing an imbalance with a plug ("other liabilities" balancing figure). The plug hides the broken link and the model will be wrong in every scenario.
Double counting interest — once in CFO (from PAT) and again in CFF — or omitting it from both.

Key terms¶

Term	Meaning
Linkage	A rule tying a line in one statement to a line in another (e.g., PAT → retained earnings)
Roll-forward	Opening balance + additions − deductions = closing balance, for a balance-sheet line
Tie-out	Rebuilding one statement from the others and reconciling the differences
Balance check	Total assets − (total liabilities + equity); must be zero
Cash check	Closing cash per the cash-flow statement = cash on the balance sheet
Plug	The line a model uses to force balance — should be cash or a revolver, never an arbitrary "other"
Revolver	A revolving credit facility used in models to fund any cash shortfall
Capital creditors	Amounts owed for capex already received; investing-related, not working capital
Non-cash transaction	A transaction with no cash movement (new lease, share-funded acquisition, capex on credit)
Deferred tax	Tax expense not currently payable (or recoverable), arising from timing differences
Statement of changes in equity (SOCE)	Primary statement reconciling opening and closing equity by component
Circularity	A loop in a model (interest ↔ debt ↔ cash) that needs iteration or an opening-balance convention
Accrual	An expense or revenue recognised before the related cash moves (e.g., bonus accrued)
Prepaid expense	Cash paid before the expense is recognised; an asset until used

Check your understanding¶

On 31-Mar-2026 Noyyal also received a ₹5.0 lakh advance from a customer for pumps to be repaired in April. Restate Noyyal's FY26 PAT, CFO, closing cash and total assets.

Answer

PAT is unchanged at ₹10.5 lakh — no revenue is earned yet. The advance is a contract liability (other current liability) of ₹5.0 lakh. CFO rises by 5.0 to ₹26.5 lakh (increase in other current liabilities); closing cash rises to ₹22.5 lakh; total assets become 121.5 + 5.0 = ₹126.5 lakh, matched by liabilities of +5.0.

Rebuild Kaveri's FY25 capex on PP&E from the balance sheets. (FY24: net block 475.9, CWIP 0.0; FY25: net block 484.9, CWIP 4.0; FY25 PP&E depreciation 37.0; a land parcel with book value ₹4.0 Cr was sold.)

Answer

Closing (net block + CWIP) = opening + capex − depreciation − book value of disposals. So capex = (484.9 + 4.0) − (475.9 + 0.0) + 37.0 + 4.0 = 13.0 + 37.0 + 4.0 = ₹54.0 Cr ✓ — matching the "purchase of PP&E incl. CWIP" line. Forgetting the land disposal gives ₹50.0 Cr, a ₹4.0 Cr error.

Kaveri decides to shorten the useful life of its motors plant, raising FY27 book depreciation by ₹8.0 Cr. Tax depreciation is unchanged. What happens to FY27 EBITDA, PAT, CFO, net block and the deferred tax liability? (Tax rate 25.17%.)

Answer

EBITDA: unchanged. PBT −8.0; current tax unchanged; deferred tax credit of 8.0 × 25.17% = 2.0; PAT falls by 8.0 × (1 − 0.2517) = ₹6.0 Cr. CFO: unchanged (PAT −6.0 + depreciation +8.0 − deferred-tax credit 2.0). Net block −8.0; deferred tax liability −2.0; equity −6.0; the balance sheet still balances. (If the higher depreciation were also tax-deductible, current tax would fall by 2.0 and CFO would rise by 2.0.)

Your Kaveri model balances in FY26 but in FY27 total assets exceed liabilities plus equity by exactly ₹154.0 Cr. What is your first hypothesis, and why?

Answer

An imbalance of exactly twice a line item suggests a sign error on that item. ₹154.0 Cr = 2 × 77.0, the size of an increase-in-receivables line — so check whether the FY27 change in receivables (or another working-capital item of ₹77.0 Cr) has been added in CFO instead of deducted. More generally, search for items equal to the imbalance and to half of it.

Derive Kaveri's FY26 dividends paid in two independent ways, and the FY26 ESOP charge, using only the balance sheets, the P&L and the per-share data.

Answer

(1) Per-share data: DPS paid in FY26 ₹4.0 × 6.00 Cr shares = ₹24.0 Cr. (2) Equity roll-forward: dividends = PAT + other credits to equity − Δ other equity; if you know the ESOP charge (₹2.4 Cr, disclosed inside employee cost), 90.5 + 2.4 − 68.9 = ₹24.0 Cr. Conversely, knowing dividends, ESOP = 68.9 − 90.5 + 24.0 = ₹2.4 Cr. You need one of the two from the notes; the statement of changes in equity gives both.

On 31-Mar-2026 Kaveri takes delivery of a ₹10.0 Cr machine on 90-day credit. Show the effect on the FY26 and FY27 statements. What goes wrong if an analyst includes the amount owed in "other current liabilities" when computing working capital?

Answer

FY26: PP&E +10.0; capital creditors (other financial liabilities) +10.0; no P&L or cash effect. FY27: cash −10.0 in CFI (capex) when paid; depreciation begins. If the ₹10.0 Cr is lumped into working-capital liabilities, FY26 CFO is overstated by 10.0 (a liability "increase") and FY26 capex overstated by 10.0 — cash still ties, so the balance check won't catch it; then in FY27 CFO is understated by 10.0. Always strip capital creditors out of working capital.

Explain why Kaveri's CFO is the same whether you start from PBT (deducting taxes paid) or from PAT (adding back deferred tax).

Answer

PAT = PBT − current tax − deferred tax. The PBT route deducts taxes paid (29.5), which here equals current tax because no tax payable or refund balance moved. The PAT route has already deducted current tax (29.5) and deferred tax (1.0); adding back the non-cash deferred portion leaves exactly the current tax deducted. Numerically, 121.0 − 29.5 = 91.5 = 90.5 + 1.0. If tax payable had changed, both routes would need the same extra adjustment.

A model's balance check is zero in the first forecast year and then off by an amount that grows each year by roughly the depreciation charge. Where do you look?

Answer

A recurring flow booked in some statements but not others. The pattern matches D&A: probably depreciation is charged in the P&L and added back in CFO, but the fixed-asset schedule doesn't deduct it (assets overstated, growing each year by that year's D&A) — or the fixed-asset schedule deducts it but the CFO add-back is missing (cash understated). Check the fixed-asset roll-forward first, then the CFO add-back.

Go deeper¶

Simon Benninga, Financial Modeling (MIT Press) — the classic spreadsheet treatment of pro-forma statements, the cash/debt plug and circularity.
Stephen Penman, Financial Statement Analysis and Security Valuation (McGraw-Hill) — reformulated statements and why the linkages matter for valuation.
Ind AS 7, Statement of Cash Flows — read paragraphs 43–44E on non-cash transactions and the reconciliation of financing liabilities.
tools/fi/model.py::project and its checks frame — run the course's projection engine on Kaveri and deliberately break a linkage to see the balance check react (see 10.5).

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