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.
Behind the balance sheet · 1 of 17Next: Accrual Accounting
The Three Financial Statements · the mechanism
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Push any single event through all three statements in the right order, with the right signs, and prove the balance sheet balances.
Where it comes up. A VP checking your model asks what happens if the write-down goes through, and expects you to walk it to the balance sheet without opening a spreadsheet.
Income statement first, always
Find the effect on pre-tax income, apply the tax rate, and you have the change in net income. Every flow-through starts here because the other two statements both depend on it.
Cash flow second, starting from net income
Take the change in net income, then add back anything non-cash that caused it, and adjust for working capital and any investing or financing movement. The output is the change in cash.
Balance sheet last, and prove it
Move cash by the amount the cash flow statement produced, move whatever asset or liability the event touched, and move retained earnings by the change in net income. Then say out loud that assets equal liabilities plus equity. Interviewers wait for that sentence.
Worked through
Depreciation increases by $10, at a 25% tax rate.
- Income statement
- Operating income −$10, tax −$2.50, net income −$7.50
- Cash flow
- Net income −$7.50, add back $10 non-cash, cash +$2.50
- Balance sheet, assets
- Cash +$2.50, PP&E −$10, so assets −$7.50
- Balance sheet, equity
- Retained earnings −$7.50
Assets fall $7.50 and equity falls $7.50, so it balances. Cash went UP, which is the answer that catches people: depreciation is non-cash, and that is exactly why the tax it saves is real money.
Check yourselfThe company is loss-making and pays no tax. Same $10 of depreciation. What happens to cash?
Answer once you have one →
Nothing. The $2.50 of cash came entirely from the tax saved, and a company with no tax bill saves nothing. Net income falls the full $10, the add-back is $10, and cash is unchanged. This is why the value of a depreciation tax shield depends on there being profit to shield.
Be able to say this back next week
- Ran the order: income statement, then cash flow, then balance sheet
- Added back non-cash items on the cash flow rather than ignoring them
- Finished by proving the balance sheet balances rather than asserting it
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 is a $10 rise in depreciation at a 25% tax rate, worked through in full above. Net income falls $7.50, cash rises $2.50 because of the tax saved, and the sheet balances with assets and equity both down $7.50.
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.
Where The Three Financial Statements comes up
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