The Three Financial Statements
The income statement (performance over a period), balance sheet (financial position at a point in time) and cash flow statement (cash movements over a period). "Walk me through how they link" is among the most common interview questions in finance.
Why The Three Financial Statements matters in interviews
"Walk me through the three statements" and "how does a $10 increase in depreciation flow through" are the most-asked technical questions in finance recruiting, full stop. They test the one thing that cannot be faked: whether you understand that accounting is a closed system.
How it works in practice
The income statement measures profitability over a period, ending in net income. The balance sheet is a snapshot at a point in time where assets equal liabilities plus equity. The cash flow statement reconciles net income to the actual change in cash, split into operating, investing and financing activities.
They link in three places: net income flows to the top of the cash flow statement and into retained earnings on the balance sheet; the closing cash balance from the cash flow statement becomes the cash line on the balance sheet; and non-cash items and balance sheet movements are the adjustments in between.
The canonical test: depreciation rises by $10 with a 25% tax rate. Income statement — EBIT falls $10, net income falls $7.50. Cash flow — start at −$7.50, add back the $10 non-cash charge, so cash rises $2.50. Balance sheet — cash up $2.50, PP&E down $10, so assets fall $7.50; retained earnings fall $7.50. It balances, and the business is $2.50 better off in cash because of the tax shield.
What candidates get wrong
- Not tax-affecting the change. The whole point of the depreciation question is the tax shield.
- Failing to state explicitly that the balance sheet balances at the end. Interviewers wait for it.
- Rushing. Walk each statement in order, say the number, then move on. Structure is the mark.
The Three Financial Statements: frequently asked questions
How does a $10 increase in depreciation affect the three statements?
At a 25% tax rate: on the income statement, EBIT falls by $10 and net income falls by $7.50. On the cash flow statement, you start from net income of −$7.50 and add back $10 of non-cash depreciation, so cash increases by $2.50. On the balance sheet, cash rises $2.50 and PP&E falls $10 for a $7.50 fall in assets, matched by a $7.50 fall in retained earnings. It balances, and cash is higher because depreciation reduced the tax bill.
Which statement is most important?
The cash flow statement, in most practitioners' view, because it is the hardest to manipulate. Revenue recognition and accruals give management discretion over reported earnings; cash movements are far more difficult to dress up. Investors who focus on one statement usually focus on this one.
Go deeper
This term comes up constantly in accounting interviews and on the desk.
IB technical questions guideRelated Accounting terms
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