The question 'walk me through how the three financial statements link together' appears in virtually every investment banking interview. It tests whether you actually understand accounting or have just memorised definitions. This guide shows you exactly how the Income Statement, Balance Sheet, and Cash Flow Statement connect, with the worked examples interviewers expect you to know.
The Core Links
There are three fundamental connections between the statements. Understand these and you can trace any transaction through all three.
Link 1: Net Income Connects the Income Statement to Everything
Net Income is the bottom line of the Income Statement. It flows into two places:
First, it's the starting point of the Cash Flow Statement (Cash Flow from Operations begins with Net Income). Second, it increases Retained Earnings on the Balance Sheet under Shareholders' Equity. If the company earned £50m of Net Income and paid £10m in dividends, Retained Earnings increases by £40m.
Link 2: Non-Cash Charges Bridge the Income Statement and Cash Flow Statement
The Income Statement includes non-cash expenses like Depreciation & Amortisation. These reduce Net Income but don't actually cost cash. So on the Cash Flow Statement, we add them back to Net Income to get the true cash generated from operations.
Meanwhile on the Balance Sheet, Depreciation reduces the value of PP&E (Property, Plant & Equipment) on the asset side. So £10m of depreciation reduces Net Income by £10m (after tax), gets added back on the CFS, and reduces PP&E by £10m on the BS.
Link 3: Cash on the Cash Flow Statement Ties to Cash on the Balance Sheet
The Cash Flow Statement ends with a 'Net Change in Cash' figure. Add this to the beginning cash balance, and you get the ending cash balance – which must exactly match the Cash and Cash Equivalents line on the Balance Sheet. If it doesn't, something is wrong with the model.
The Classic Interview Question: 'Depreciation Increases by £10'
This is probably the single most-asked technical question in IB interviews. Here's how to walk through it, step by step, assuming a 25% tax rate:
Income Statement Impact
Depreciation is an operating expense, so EBIT falls by £10. However, because depreciation is tax-deductible, the company pays less tax. Tax savings: \text{Tax Savings} = £10 \times 25\% = £2.50. So Net Income falls by £7.50 (the £10 expense minus the £2.50 tax saving).
Cash Flow Statement Impact
We start with Net Income, which is down £7.50. But depreciation is a non-cash charge, so we add back the full £10. Net cash impact from operations: -£7.50 + £10 = +£2.50. Cash actually increases by £2.50 because of the tax shield.
Balance Sheet Impact
Assets: PP&E decreases by £10 (the depreciation charge). Cash increases by £2.50 (from the CFS). Total assets decrease by £7.50.
Liabilities: Tax payable decreases by £2.50 (lower tax bill). Shareholders' Equity: Retained Earnings decreases by £7.50 (lower Net Income). But we need the Balance Sheet to balance, so let's check: Assets are down £7.50, Liabilities are down £2.50, Equity is down £7.50? That doesn't balance.
The resolution: Total Assets are down £7.50 (PP&E --£10, Cash +£2.50). Total L+E must also be down £7.50. Liabilities down £2.50 (tax) + Equity down £5.00... wait. Let's be precise: Retained Earnings is down £7.50
(Net Income impact) and Tax Liability is down £2.50. So L+E = --£2.50 + (--£7.50) = --£10. But Assets are only down £7.50. The issue is that the
tax saving creates a £2.50 cash increase that offsets part of the PP&E decline.
Correctly: Assets decline by £7.50 net (PP&E --£10 + Cash +£2.50). Liabilities + Equity must also decline by £7.50. Tax payable falls £2.50 and Retained Earnings falls £7.50, giving a --£10 total. But we also need to account for the deferred tax impact properly, depending on whether this is a book/tax difference. In the simplest version for interviews: Assets down £7.50 = Equity down £7.50. The balance sheet balances.
In an interview, keep it simple: 'Net Income falls by £7.50. On the CFS, we add back the £10 depreciation, so cash is up £2.50. On the BS, PP&E is down £10, cash is up £2.50, so total assets are down £7.50. Retained earnings is down £7.50. The balance sheet balances.' Don't overcomplicate the tax payable – the interviewer will follow up if they want more.
Other Key Connections to Know
Capital Expenditure
CapEx does not appear on the Income Statement at all (it's capitalised, not expensed). It shows up as a cash outflow on the Cash Flow Statement under Investing Activities. And it increases PP&E on the Balance Sheet. Over time, that PP&E is depreciated, which does hit the Income Statement. So CapEx affects the IS indirectly, through future depreciation.
Working Capital Changes
If Accounts Receivable increases by £20m, that means the company earned revenue (IS impact) but hasn't collected the cash yet. So on the CFS, we subtract the £20m increase because it's not real cash. On the BS, AR (an asset) is up £20m.
If Accounts Payable increases by £15m, the company incurred expenses but hasn't paid cash yet. On the CFS, we add this back because we kept the cash. On the BS, AP (a liability) is up £15m.
The general rule: increases in current assets use cash (subtract on CFS), increases in current liabilities provide cash (add on CFS).
Debt Issuance / Repayment
Issuing £100m of debt: no IS impact. Cash inflow of £100m on CFS (Financing Activities). Cash up £100m and Debt up £100m on BS. Future interest payments will hit the IS. Repaying debt is the reverse.
Share Buyback
If the company repurchases £50m of shares: no IS impact. Cash outflow of £50m on CFS (Financing Activities). Cash down £50m and Shareholders' Equity down £50m on BS (Treasury Stock increases).
How to Answer 'Walk Me Through the Financial Statements'
Keep it structured and concise:
The three statements are the Income Statement, Balance Sheet, and Cash Flow Statement. They're linked in several ways. Net Income from the Income Statement is the starting point of the Cash Flow Statement and flows into Retained Earnings on the Balance Sheet. Non-cash charges like D&A reduce Net Income but are added back on the Cash Flow Statement since they don't affect cash. Capital expenditure shows up as a cash outflow on the CFS and increases PP&E on the Balance Sheet. Working capital changes adjust cash flow for timing differences between revenue/expenses and actual cash collection/payment. And the ending cash balance on the Cash Flow Statement ties directly to the Cash line on the Balance Sheet.
Master the three financial statements
Our AI tutor can walk you through 50+ variations of this question.
Get started for free
