Walk me through the three financial statements

What is the answer you give out loud?

Interviewers want about 45 seconds: one line per statement, then the links. Say it in this order every time, so it becomes automatic and you have room to think on the follow up, which is where the real test is.

Keep the definitions short. The interviewer knows what a balance sheet is. What they are checking is whether you know which numbers move between statements and why.

1. Income statement: revenue, less cost of goods sold and operating expenses, gives operating income; less interest and taxes gives net income, over a period such as a year.
2. Balance sheet: at one point in time, assets equal liabilities plus shareholders' equity.
3. Cash flow statement: start with net income, add back non cash charges like depreciation, adjust for changes in working capital to get cash from operations, then add cash from investing (capex, acquisitions) and from financing (debt, stock, dividends) to get the net change in cash.
4. Link one: net income is the first line of the cash flow statement and, less dividends, flows into retained earnings on the balance sheet.
5. Link two: ending cash on the cash flow statement is the cash line on the balance sheet.
6. Link three: depreciation reduces PP&E on the balance sheet, capex increases it, and changes in working capital accounts show up in cash from operations.

What happens if depreciation goes up by 10?

This is the follow up you will almost certainly get. Assume a 25 percent tax rate and say the assumption out loud before you start. Walk the statements in the order cash actually moves: income statement, then cash flow statement, then balance sheet, and finish by showing it balances.

The intuition: depreciation is a non cash expense, so it does not cost cash itself, but it is tax deductible, so it saves taxes. With a 25 percent rate, 10 of extra depreciation saves 2.5 of tax, and cash goes up by exactly that.

1. Income statement: depreciation up 10, so operating income and pre tax income fall by 10. Taxes fall by 2.5 (25 percent of 10). Net income falls by 7.5.
2. Cash flow statement: net income is down 7.5, but you add back the 10 of depreciation because it was non cash. Cash from operations is up 2.5, and the net change in cash is up 2.5.
3. Balance sheet, assets: cash is up 2.5 and PP&E is down 10, so total assets are down 7.5.
4. Balance sheet, liabilities and equity: liabilities do not change. Retained earnings fall by the 7.5 drop in net income, so equity is down 7.5.
5. Check: assets down 7.5, liabilities and equity down 7.5. It balances.

Why do some answers say net income falls by 6?

Because they assume a 40 percent tax rate, which was the old convention before the 2017 US corporate rate cut and still appears in many prep materials, including some of the drills here. At 40 percent, taxes fall by 4, net income falls by 6, and cash rises by 4. The structure is identical; only the tax line changes.

If the interviewer gives you a rate, use it. If they do not, pick one, say it, and run the numbers. Using 25 percent shows you know the current federal rate plus a typical state burden; any stated, consistent rate is a correct answer.

• At 25 percent: net income down 7.5, cash up 2.5, PP&E down 10, assets and equity both down 7.5.
• At 40 percent: net income down 6, cash up 4, PP&E down 10, assets and equity both down 6.
• Shortcut that works at any rate: cash changes by the rate times the depreciation, and net income changes by one minus the rate times the depreciation.

What other walk through questions come up?

Once you can do depreciation, the same three step method handles every variation. Here is a harder one at the same 25 percent rate: a company buys 100 of equipment with 100 of new debt, then after one year records 10 of depreciation and pays 5 percent interest.

At purchase there is no income statement effect. Investing cash flow is minus 100 and financing is plus 100, so cash is unchanged, and the balance sheet shows PP&E up 100 and debt up 100. After a year, depreciation of 10 and interest of 5 cut pre tax income by 15; taxes fall by 3.75, so net income falls by 11.25. On the cash flow statement, add back the 10 of depreciation, so cash falls by 1.25. On the balance sheet, cash is down 1.25 and PP&E down 10, so assets are down 11.25, matched by retained earnings down 11.25. The cash result turns on taxes: at 25 percent the tax saved, 3.75, is less than the 5 of cash interest, so cash falls. At a 40 percent rate, as in the drill, the tax saved is 6, net income falls by 9, and cash rises by 1.

Practice the live questions below until you can do each without paper. The drill grades you and tracks which ones you miss.

What mistakes cost people this question?

Almost nobody fails this question on definitions. They fail it on the follow up, by losing track of a number or forgetting a link. These are the slips interviewers see most.

• Forgetting to tax the change: saying net income falls by the full 10.
• Forgetting the add back on the cash flow statement, so cash appears to fall.
• Moving PP&E in the wrong direction or forgetting it entirely, so the balance sheet does not balance.
• Starting with the balance sheet, which makes the chain hard to follow.
• Never stating a tax rate, so the interviewer cannot tell whether your numbers are right.
• Rambling through every line item instead of naming only the lines that change.

Questions students ask

Which statement is the most important?

If you could have only one, most bankers pick the cash flow statement, because cash is what pays debt and funds the business, and it is harder to dress up than net income. Say that and give the reason.

If you could use two statements, which would you pick?

The income statement and the balance sheet, because you can build the cash flow statement from them: start with net income and take the changes in each balance sheet account.

Does depreciation affect cash?

Not directly, because it is non cash. It affects cash only through taxes: higher depreciation lowers taxable income, so the company pays less tax and keeps more cash, equal to the tax rate times the depreciation.

What tax rate should I use if they do not give one?

Pick a round number, say it out loud, and use it consistently. 25 percent is a sensible US default today, and 40 percent is common in older prep material. The interviewer cares that the math follows from your stated rate.

How long should my answer be?

About 45 seconds for the walk through, then stop and let them ask. A short, ordered answer signals that you know where the important links are.