The balance sheet and cash flow

The income statement told you whether Sokoni made a profit. It cannot tell you whether Sokoni has any money — those are different questions, and answering the second is the job of the other two statements. The balance sheet is a photograph taken at the last instant of the period: everything the business controls, and every claim against it, frozen at that moment. The cash-flow statement is the reconciliation between two consecutive photographs — it explains, line by line, how the cash balance moved from the start of the year to the end. In this module you build both for Sokoni and wire the one link that makes a three-statement model a model rather than three spreadsheets sharing a workbook. All Sokoni figures are in KES.

The balance sheet is an identity

A balance sheet has two sides that are equal by construction: Assets = Liabilities + Equity. The left side lists what the business controls; the right side lists who has a claim on it — lenders first, owners last. For Sokoni the asset side is four lines: cash; accounts receivable (money customers owe for goods already delivered); inventory (goods bought or made but not yet sold); and net property, plant and equipment (the depreciated book value of the long-lived assets). The claim side is three: accounts payable (money Sokoni owes suppliers); interest-bearing debt; and equity, which is share capital plus retained earnings. Five real asset and liability lines, and equity underneath — that is the whole structure.

The equality is not something you arrange; it is a consequence of how every transaction is recorded. Buy KES 100 of inventory on credit and two things move together: inventory rises by 100 and accounts payable rises by 100. Pay a supplier and cash falls while payables fall by the same amount. Every transaction touches the sheet in two equal and opposite places — that is what double-entry bookkeeping means — so the two sides cannot drift apart if the bookkeeping is honest. This matters enormously for the modeller: when a model's balance sheet does not balance, it is never the accounting identity that has failed. It is always a link in your spreadsheet that has, and the next module is entirely about finding it.

Retained earnings: the hinge between the statements

Only one line on the balance sheet connects it to the income statement, and it is retained earnings — the running total of every profit the company has ever earned and not paid out. It rolls forward by a single rule: RE(t) = RE(t−1) + net income − dividends. Sokoni is a going concern with a history, so it opens Year 0 with retained earnings of KES 206,849 — the figure that makes the opening balance sheet balance, given cash of 100,000, receivables of 82,192, inventory of 98,630 and net PP&E of 500,000 on the asset side, against payables of 73,973, debt of 300,000 and share capital of 200,000 on the claim side. In Year 1 it earns net income of KES 93,800 and pays dividends of KES 18,760 (twenty per cent of profit), so closing retained earnings is 206,849 + 93,800 − 18,760 = KES 281,889. That one number carries the entire income statement onto the balance sheet. Get the roll-forward wrong — add dividends instead of subtracting them, or forget them — and the sheet will not balance, which is precisely how you will catch the mistake.

The indirect cash-flow statement

Profit is an opinion; cash is a fact. The gap between them is created by accruals — revenue booked before the customer pays, costs matched before the supplier is paid, and non-cash charges like depreciation that reduce profit without moving any money. The indirect cash-flow statement starts from net income and undoes every one of those accruals to arrive at cash actually generated. Operating cash flow is net income, plus depreciation and amortisation (a non-cash expense, added straight back), minus the increase in net working capital (the cash swallowed by growing receivables and inventory, net of the financing that suppliers extend through payables): CFO = net income + D&A − ΔNWC.

Below operating cash flow sit two more sections. Investing cash flow, for Sokoni, is simply the cash spent on new fixed assets: CFI = −capex. Financing cash flow is the cash returned to capital providers: CFF = −debt repayment − dividends. Add the three sections for the net change in cash, then add that to the opening balance for the closing balance. Because Sokoni is an established business rather than a startup, its opening balance sheet already carries receivables, inventory and payables — net working capital was KES 106,849 at the end of Year 0 (receivables 82,192 plus inventory 98,630 less payables 73,973). Year 1 does not suffer a first-year working-capital shock; it only funds the increase needed to support 10% more revenue, and net working capital rises to KES 117,534, so ΔNWC is just KES 10,685. Year 1 operating cash flow is therefore 93,800 + 50,000 − 10,685 = KES 133,115 — comfortably above net income, because depreciation adds back more than the working-capital build takes out. Investing cash flow is −132,000 (capex at 12% of revenue); financing is −50,000 − 18,760 = −68,760. Net change in cash is 133,115 − 132,000 − 68,760 = negative KES 67,645, and against opening cash of 100,000 that leaves closing cash of KES 32,355 — still positive, but already falling because the capex programme outruns the cash operations throw off.

• Net income: KES 93,800 — the starting point, taken straight from the income statement
• Add depreciation: KES 50,000 — a non-cash charge that reduced profit but moved no cash
• Less increase in net working capital: KES 10,685 — net working capital rising from 106,849 to 117,534 as receivables and inventory grow with sales, net of payables
• Operating cash flow (CFO): KES 133,115 — above net income, because depreciation adds back more than the working-capital build absorbs
• Investing cash flow (CFI): negative KES 132,000 — capex at 12% of revenue
• Financing cash flow (CFF): negative KES 68,760 — debt repayment 50,000 plus dividends 18,760
• Net change in cash: negative KES 67,645
• Opening cash 100,000, closing cash: KES 32,355 — still positive in Year 1, but the capex programme is already outrunning operating cash

With the link in place, Sokoni's Year-1 balance sheet balances to the cent. Assets: cash 32,355, receivables 90,411, inventory 108,493, net PP&E 582,000 (opening 500,000 plus capex 132,000 less depreciation 50,000) — total KES 813,259. Claims: payables 81,370 plus debt 250,000 gives liabilities of 331,370; share capital 200,000 plus retained earnings 281,889 gives equity of 481,889 — total KES 813,259. The two sides agree exactly, and they will agree in every one of the five forecast years. Nothing was forced to make that happen; it fell out of two correct links and the identity.