Three-statement flow-through

"Depreciation goes up by £10. Walk me through the three statements." This question, and dozens of variations on it, is a staple of investment banking superdays. Interviewers use it to see whether you understand how the statements connect, and whether you stay calm and structured under pressure. The good news is that one method answers every version.

The method

• Income statement: what happens to operating profit, tax and net income?
• Cash flow statement: start from the change in net income, reverse anything non-cash, adjust for working capital, then add investing and financing flows
• Balance sheet: cash from the cash flow statement, the other assets and liabilities that moved, and retained earnings from net income
• Check: does the change in assets equal the change in liabilities plus equity?

State your assumptions at the start. In this lesson, tax is paid in cash in the same year at a flat rate, there is no deferred tax, and the expenses discussed are tax-deductible. Interest paid is shown in operating cash flow. Interviewers usually give a tax rate; if not, pick 25%, the UK main rate, and say so.

The classic: depreciation up £10

Say it in words: operating profit falls by £10, tax falls by £2.50, so net income falls by £7.50. On the cash flow statement, net income is down £7.50 but depreciation is non-cash, so add back £10, and cash is up £2.50. On the balance sheet, cash is up £2.50 and PP&E is down £10, so assets are down £7.50. Retained earnings are down £7.50, so liabilities and equity are down £7.50 too. It balances.

The insight to mention is that the company is better off in cash terms by the tax saved on the extra depreciation. Depreciation itself uses no cash, but it reduces the tax bill.

Variations that come up

Inventory write-down of £20m

This works exactly like depreciation. Net income falls by £15m at 25% tax. The write-down is non-cash, so it is added back, and cash rises by £5m, the tax saved. Inventory falls by £20m and cash rises by £5m, so assets fall by £15m, matching the fall in retained earnings.

An accrued bonus of £8m, paid next year

The expense is recognised now, so net income falls by £6m. No cash has left for the bonus, and accrued liabilities rise by £8m, which is added back as a working capital movement: −£6m + £8m = +£2m of cash. On the balance sheet, assets rise by the £2m of cash; liabilities rise by £8m and equity falls by £6m, a net +£2m. Next year, when the bonus is paid, cash falls by £8m and the accrual disappears.

Buying £100m of equipment with a new loan

Nothing hits the income statement on day one. Investing cash flow is −£100m and financing cash flow is +£100m, so net cash is unchanged. PP&E and borrowings both rise by £100m. Over the following years, depreciation and interest flow through the income statement, each reducing net income by the after-tax amount.

Selling an asset for more than its book value

A £50m sale on credit of goods that cost £30m

Revenue rises £50m and cost of sales £30m, so profit before tax rises £20m and net income £15m. Receivables rise by £50m, a use of cash, and inventory falls by £30m, a source of cash: £15m − £50m + £30m = −£5m. Cash falls by the £5m of tax, because the customer has not paid yet. Assets rise by £15m (receivables +£50m, inventory −£30m, cash −£5m), matching retained earnings.

Interest of £12m paid in cash

Net income falls £9m. Interest is a real cash cost, so nothing is added back and cash falls £9m. Assets and equity both fall £9m.

IFRS 16 leases

Under IFRS 16, a new lease creates a right-of-use asset and a lease liability of the same amount, with no income statement effect on day one. Each year, the asset is depreciated and interest accrues on the liability, so the single rent expense of older rules is replaced by depreciation and interest. Operating cash flow rises, because depreciation is added back, while the principal part of lease payments sits in financing cash flow. That is why EBITDA and operating cash flow both look higher under IFRS 16.

Common mistakes

• Forgetting tax, so cash appears unchanged when depreciation rises
• Adding back the full pre-tax amount to net income instead of starting from the after-tax change
• Getting working capital signs backwards: more assets use cash, more liabilities provide it
• Double counting a gain on sale in both operating and investing cash flow
• Forgetting that cash on the balance sheet must equal the net change on the cash flow statement