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How does a $10 depreciation affect the three financial statements?



How to answer: $10 depreciation and the three financial statements


“How does a $10 depreciation affect the three financial statements?”

The short answer:

  • P&L: EBIT -10, Pre-Tax Income -10, Net Income -7 (assuming 30% tax rate)

  • Cash Flow Statement: Net Income -7, D&A +10, Total Cash Flow +3

  • Balance Sheet: Retained Earnings -7 from Net Income, PP&E -10, Cash +3 and the Balance Sheet balances

This is one of the absolute classic interview questions and has not changed for years. We like to ask this question because it captures all the mechanics of the three statements in one question. You will 100% get this question in an Investment Banking interview. This question usually comes after the “walk me through the three financial statements” question.



The more detailed answer


P&L

  • Revenues: no changes

  • Gross Profit: no changes

  • EBITDA: no changes

  • D&A: +10 because it’s an expense

  • EBIT: -10

  • Pre-Tax Income: -10, which decreases taxable income

  • Net Income: -7 (assuming a tax rate of 30%) because we are saving 3 in tax expenses

Cash Flow Statement

  • Net Income: -7 from the P&L

  • D&A: +10, because it’s a non-cash expense and needs to be added back

  • Net Cash Flow: +3, this is where you capture the tax effect

Balance Sheet

  • Now it’s time to put everything together

  • Equity and Liabilities side: Net Income -7 flows into Retained Earnings. Total equals -7

  • Assets side: PP&E -10 because of D&A +10. Cash +3 from Net Cash Flow. Total equals -7

  • The Balance Sheet balances and you are done


Making all the connections may take a couple of practice runs. So, it’s best to try multiple cases and get some practice with the thinking pattern. We think the best way to tackle these questions is to stay consistent with one order. In our case, it’s P&L, Cash Flow Statement and finishing off with the Balance Sheet. Don’t mix up the order. You need to have a consistent and repeatable process when it’s crunch time during an interview.



Most common mistakes


Accounting questions can be tricky and require a bit of preparation. From our experience, here are the most common mistakes we see during interviews:


Starting with the Balance Sheet or changing the order every time


This is how you mess up every single time. You need to have a repeatable process for accounting questions. Pick an order and stick with it for every single accounting question. This is how we would do it:

  1. P&L

  2. Cash Flow Statement

  3. Balance Sheet

(1) Always start with the P&L. (2) Then let Net Income flow through the Cash Flow Statement. Going through the Cash Flow Statement, consider whether the changes are cash or non-cash. Net Cash Flow will then flow into Cash and Equivalents on the Balance Sheet. (3) Lastly, go through both sides of the Balance Sheet: Assets and Equity & Liabilities. Once the Balance Sheet balances, you are done.



Your Balance Sheet does not balance

If you walk yourself through accounting questions and your Balance Sheet does not balance, the answer is wrong. Assets always equal Equity & Liabilities. It’s hard to mend the situation and go back to correct your mistake in an interview setup. Better to have some more practice. Getting those basic accounting questions wrong will get you dinged. Here are the connecting points of the three financial statements for this example:

  • Net Income (P&L) flows into the opening line of the Cash Flow Statement

  • D&A (P&L) flows into the Cash Flow Statement

  • Net Cash Flow (Cash Flow Statement) flows into Cash & Equivalents (Asset side of the Balance Sheet)

  • D&A (P&L) flows into PP&E (Asset side of the Balance Sheet)

  • Net Income (P&L) flows into Retained Earnings (Equity & Liabilities side of Balance Sheet)

  • Once the Balance Sheet balances and you are done



You are taking too long


You should be able to answer those accounting questions fluently. This should take about 30 seconds to 1 minute. If you are struggling, it’s a sign that you have not prepared yourself for the interview. This makes you look bad. Don’t fall for the most common interview mistakes – especially with all the free content out there.



Memorizing without understanding


You answered the question to the satisfaction of the interviewer. Maybe you answered the question too well and seemed a little bit too rehearsed. In that case, the interviewer will further probe you. We want to ensure you understand the mechanics instead of just memorizing them. You will get further questions that go off the grid of your typical interview guide. The main point is to understand the material and not just memorize it.



Additional resources


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