Depreciation goes up by $20... (Advanced)
By Michael Song · Wharton MBA · ex-Greenhill · investment banking interview coach
15 min read · updated August 10, 2026
Ask around a bullpen for the single most-asked technical and you will keep landing on this one. Not "walk me through the three statements." This one. Depreciation goes up by $20, now walk me through it.
The reason is that the plain three-statement walk can be memorized. Plenty of candidates recite what each statement does, in order, having understood none of it. The moment an interviewer moves one line and asks you to trace it, recitation stops working. You have to actually run the system.
That is why this question is the better filter, and it is why you should treat it as the one technical you cannot afford to be shaky on.
The order is the answer
Walk it in the same sequence every single time:
Income statement, then cash flow statement, then balance sheet, then back to the income statement.
That order is not a memory aid or a stylistic preference. It is the dependency chain, and each step is impossible without the one in front of it. You cannot start the cash flow statement until you know net income, because net income is its top line. You cannot fill in the cash line on the balance sheet until the cash flow statement has produced an ending cash balance. Start anywhere else and you are guessing at a number you have not derived yet, which is exactly how candidates end up plugging retained earnings to force a balance.
The last step is not a fourth statement. It is the one sentence explaining why the balance sheet balanced, and it points straight back at the statement you started on. Almost nobody says it out loud, which is exactly why it is where the offer gets won.
The walk: depreciation up $20
Say the tax rate out loud before you start. Use 40%, because there is no calculator in the room and 40% keeps every number whole.
Income statement
Depreciation is an expense. Pre-tax income falls by the full $20.
Then the tax line responds. You earned $20 less on paper, so you owe less tax. At 40% that is $8 of tax saved. Net income falls by what is left:
Net income is down $12, not $20. The gap between those two numbers is the entire lesson, and everything downstream is built on it.
Cash flow statement
Start at net income, which is down $12.
Now the correction. Depreciation is a non-cash charge. The cash for that asset left the building years ago when it was bought; this year's charge is an accounting allocation and nothing more. So you add back the full $20, not the after-tax $12.
Cash from operations is up $8, and since nothing touched investing or financing, the net change in cash is up $8 too.
Read that again, because it is the step that separates people. The add-back is bigger than the hit to net income, so cash goes up. An expense increased and the company ended the year with more money than it otherwise would have.
Balance sheet
Assets first. Cash is up $8, straight off the bottom of the cash flow statement. PP&E is down $20, because that is what depreciating an asset does to its carrying value. Assets are net down $12.
Now the other side. Net income fell $12, so retained earnings falls $12. Liabilities did not move.
Assets down $12. Liabilities plus equity down $12. It balances.
| Change | |
|---|---|
| Pre-tax income | −$20 |
| Taxes | −$8 |
| Net income | −$12 |
| Cash from operations | +$8 |
| Cash | +$8 |
| PP&E | −$20 |
| Total assets | −$12 |
| Retained earnings | −$12 |
| Liabilities + equity | −$12 |
Why cash went up when an expense went up
This is the follow-up, and it arrives more often than the original question. If depreciation is non-cash, explain how it made cash go up.
The answer is one sentence: no cash ever moved for the depreciation itself, so the only thing that moved cash was the smaller tax bill. The company wrote a check to the government that was $8 lighter. That is the tax shield, and it is the sole cash consequence a non-cash charge ever has.
Which gives you a shortcut worth memorizing:
It holds at any rate, which is the point. The arithmetic is not the mechanism:
| Tax rate | Cash change on a $20 charge |
|---|---|
| 40% | +$8 |
| 25% | +$5 |
| 21% | +$4.20 |
| 0% | $0 |
Look at the last row. With no taxes, net income falls the full $20, you add back the full $20, and cash does not move one cent. That is the cleanest possible proof that the tax shield is the whole cash story. If an interviewer asks "what if there were no taxes," the answer is that cash is unchanged, and being able to say it instantly proves you derived the walk rather than memorized it.
Then connect it back to the income statement
Almost every candidate ends on "and it balances," and they say it like a hope rather than a conclusion. That is the last place you can separate yourself, because the sheet balanced for one specific reason and naming it is the whole point.
It balances because net income drove retained earnings.
Look at where the $12 on each side actually came from. On the asset side, cash rose $8 and PP&E fell $20, netting to $12. On the other side, retained earnings fell $12. Those are not two numbers that happened to agree. They are the same number, because retained earnings moves by exactly the change in net income, and net income is the figure you computed in the very first step.
So the walk is a circuit rather than a line. Net income comes off the income statement and lands in two places: the top of the cash flow statement, and retained earnings inside equity. That is the connection back. The statement you started on is what feeds the equity side of the statement you finished on, and it is why the two sides of the balance sheet cannot drift apart if you did the earlier steps correctly.
Retained earnings is the wire back to the income statement. When you say "and it balances," follow it immediately with "because the $12 drop in net income flowed into retained earnings." That one clause converts a memorized ending into a demonstrated one, and it is the difference between a candidate who ran the system and a candidate who recited a result.
This is also why plugging retained earnings to force a balance is such a giveaway in a model. Retained earnings is not a free cell. It is the income statement's landing spot, so a plug there is you overwriting the very link that was supposed to prove your work.
The other loop, if they keep pushing
There is a second, longer-dated connection worth having in your pocket for a follow-up. The balance sheet you just changed is the one next year's income statement starts from. PP&E is $20 lower, so there is $20 less depreciation left to take. And you are holding $8 more cash, which earns interest income or sweeps down the revolver and lowers interest expense, so next year's interest line moves, which moves net income, which moves cash, which moves debt, which moves interest again.
That last one is the circular reference at the heart of every real three-statement model, and it is deliberate rather than a bug. The mechanics of taming it live in the debt schedule and circular references.
The two questions that solve any version of this
Interviewers rarely stop at depreciation. They will move to inventory, to deferred revenue, to a writedown, to a dividend. You do not need a memorized answer for each one. You need two questions.
1. Did it hit the income statement?
If yes, net income moves by the after-tax amount, and that is the only place tax ever enters the walk. If no, there is no tax effect anywhere, which trips up more candidates than the tax math itself.
2. Did cash actually move, and when?
If the income statement took a hit but no cash moved, add the whole charge back in operations. If cash moved without an income statement hit, it lands as a working capital change, in investing, or in financing.
Answer those two and the balance sheet is no longer a question. Cash comes off the bottom of the cash flow statement, retained earnings moves by the change in net income, and the remaining line is whatever the interviewer named in the first place.
You can call the balance before you compute it. Retained earnings always moves by exactly the after-tax change in net income, and cash always comes from the bottom of the cash flow statement. If your two sides do not tie, you have not found a balance sheet problem, you have found a missing tax effect or a missing add-back upstream.
The reference table
Four families of item, each with its own signature. Learn the signature and you never memorize a row.
Non-cash charges
Signature: net income falls by the after-tax amount, the full charge is added back, and cash rises by charge times tax rate. All figures at a 40% rate.
| Item, up $20 | Income statement | Cash flow statement | Balance sheet |
|---|---|---|---|
| Depreciation | Pre-tax −20, NI −12 | NI −12, add back +20, cash +8 | Cash +8, PP&E −20, RE −12 |
| Amortization of intangibles | Pre-tax −20, NI −12 | NI −12, add back +20, cash +8 | Cash +8, intangibles −20, RE −12 |
| PP&E writedown | Pre-tax −20, NI −12 | NI −12, add back +20, cash +8 | Cash +8, PP&E −20, RE −12 |
Working capital
Signature: the cash timing is out of step with the earnings timing. An operating asset going up uses cash; an operating liability going up is a source of cash.
| Item, up $20 | Income statement | Cash flow statement | Balance sheet |
|---|---|---|---|
| Receivables, from a credit sale | Revenue +20, NI +12 | NI +12, AR −20, cash −8 | Cash −8, AR +20, RE +12 |
| Inventory, bought for cash | None | Inventory −20, cash −20 | Cash −20, inventory +20 |
| Payables | None | AP +20, cash +20 | Cash +20, AP +20 |
| Accrued expenses, incurred | Pre-tax −20, NI −12 | NI −12, accrued +20, cash +8 | Cash +8, accrued +20, RE −12 |
| Deferred revenue, customer prepays | None | Deferred rev +20, cash +20 | Cash +20, deferred rev +20 |
Investing and financing
Signature: nothing touches the income statement on day one, so there is no tax effect, and the balance sheet moves one asset against another asset or against a liability.
| Item, $20 | Income statement | Cash flow statement | Balance sheet |
|---|---|---|---|
| CapEx | None | Investing −20, cash −20 | Cash −20, PP&E +20 |
| Debt raised | None | Financing +20, cash +20 | Cash +20, debt +20 |
| Debt repaid | None | Financing −20, cash −20 | Cash −20, debt −20 |
| Dividend paid | None | Financing −20, cash −20 | Cash −20, RE −20 |
| Share buyback | None | Financing −20, cash −20 | Cash −20, equity −20 |
| Shares issued | None | Financing +20, cash +20 | Cash +20, equity +20 |
Two honest exceptions
Most guides quietly lump every non-cash charge together and tax-effect all of them. Two do not behave that way, and knowing it is a genuine depth point.
Goodwill impairment is frequently not deductible for tax, so in many real cases there is no shield and net income falls the full $20 with no cash benefit. Interviewers usually want the tax-effected version, so give it, then add "assuming it is deductible, which for goodwill often is not."
Stock-based compensation carries its own book-versus-tax mismatch and its real cost shows up as dilution rather than as cash. It gets its own treatment in stock-based compensation.
Two rows worth staring at
Look at the accrued expenses row and the depreciation row. Both end with cash up exactly $8, and the reasons could not be more different.
Depreciation moved cash because the expense was never going to be cash at all. The accrued expense moved cash because the bill is real and simply has not been paid yet. Same number this year, completely different next year, when that accrual gets settled in cash and reverses.
Then look at the receivables row. Revenue went up, net income went up $12, and cash went down $8. You paid tax on money you have not collected. That is the exact mirror image of depreciation, and it is the reason a profitable company can run out of money. If that direction feels shaky, spend ten minutes in working capital.
Four ways this goes wrong, in the order they cost people offers.
Forgetting the tax. Saying net income falls $20 and moving on. Depreciation's entire cash effect is the tax it saves, so dropping the tax rate deletes the point of the question.
Adding back the after-tax number. You add back the full $20, not $12. The add-back reverses the accounting entry, and the accounting entry was for the whole charge.
Stopping before the balance sheet balances. Say the two sides out loud and confirm they tie. An answer that ends without the check sounds like someone who was hoping.
Applying tax to something that never hit the income statement. Deferred revenue, CapEx, a debt draw, a buyback: none of these touch pre-tax income, so none of them generate a tax effect. Candidates who learned the depreciation answer by rote reach for the tax rate reflexively and tax a line that never earned anything.
The sequels
Once you clear the first walk, the follow-ups come fast. All four are the same method run again.
"Now do year two." The same $20 charge recurs, so the same effects repeat and accumulate. PP&E has now dropped $40 in total, and it keeps going until the asset is fully depreciated and the charge stops.
"What if the asset were funded with debt?" Add interest expense to the income statement, tax-effect it along with the depreciation, and put the debt draw in financing. Nothing about the sequence changes.
"What if there were no taxes?" Cash does not move. Net income falls $20, you add back $20, and the balance sheet shows PP&E down $20 against retained earnings down $20.
"What if depreciation sits inside COGS?" It still gets added back in full on the cash flow statement. Where a non-cash charge sits on the income statement changes nothing about the walk, which is exactly why the add-back exists.
For the underlying mechanics of the charge itself, see depreciation and amortization, and for the statements as a system, walk me through the three statements.
Rehearse it out loud as one unbroken sixty-second sequence, and open by naming your tax rate so the interviewer never has to ask: "assuming a 40% tax rate, pre-tax income falls $20, taxes fall $8, so net income is down $12. On the cash flow statement I start at net income down $12 and add back the full $20 because depreciation is non-cash, so cash is up $8. On the balance sheet, cash is up $8, PP&E is down $20, so assets are down $12, and retained earnings is down $12, so it balances." Then land the two closers almost nobody says: "it balances because that $12 of net income flowed into retained earnings, and the only reason cash went up at all is the tax shield." Naming the mechanism instead of asserting the result is the depth that separates you in a Superday.
Glossary
New to the lingo? Every term used above, in plain English.
- Income statement
- The report that shows whether a company made a profit over a period, running from revenue at the top down to net income at the bottom.
- Cash flow statement
- The report that tracks the actual cash moving in and out of a company, bridging accrual profit to real cash. It explains why a profitable company can still run low on cash.
- Balance sheet
- A snapshot at a single point in time of what a company owns (assets) and what it owes (liabilities), plus the equity left for owners. Assets always equal liabilities plus equity.
- Net income
- A company profit after all expenses, interest, and taxes are taken out. It is the bottom line of the income statement, also called earnings.
- Retained earnings
- The running total of profits a company has kept over time instead of paying out to shareholders. Each period net income adds to it.
- Non-cash charge
- An expense that lowers reported profit but involves no cash leaving the company, such as depreciation or amortization. It gets added back on the cash flow statement.
- D&A (Depreciation and Amortization)
- Spreading the cost of long-lived assets over the years they are used. Depreciation is for physical assets, amortization for intangible ones. Both are non-cash expenses.
- PP&E (Property, Plant and Equipment)
- The long-lived physical assets a company uses to operate, like buildings, machines, and equipment. Its value drops over time through depreciation.
- Tax shield
- The tax a company saves because an expense is deductible. Depreciation, for example, lowers taxable income, so it saves cash on taxes even though it is non-cash.
- Deferred revenue
- Cash a company has collected for a product or service it has not delivered yet, like an annual subscription paid up front. It sits as a liability until it is earned.
- Accounts receivable (AR)
- Money customers owe a company for sales already made but not yet paid for. It is an asset, and it ties up cash until the customer pays.
- Accounts payable (AP)
- Money a company owes its suppliers for goods or services it has received but not yet paid for. It is a liability, and it is a source of short-term financing.
- Working capital
- The short-term money tied up in day-to-day operations, roughly current assets like receivables and inventory minus current liabilities like payables.
- CapEx (Capital Expenditures)
- Cash a company spends to buy or upgrade long-lived assets like equipment, factories, or technology. It is an investment in the business, not a day-to-day expense.
- Revolver (revolving credit facility)
- A flexible line of credit a company can draw on and repay as needed, like a corporate credit card. In a model it plugs any short-term cash shortfall.
- Circular reference
- In a model, when two calculations depend on each other, like interest depending on debt while debt depends on cash that depends on interest. Solved by enabling iterative calculation.
- Goodwill
- An accounting plug created when a buyer pays more for a company than the fair value of its identifiable net assets. It captures things like brand and customer relationships.
- Impairment
- A write-down taken when an asset, often goodwill, is worth less than its value on the books. It is a non-cash charge that lowers reported profit.
- Amortization
- Spreading the cost of an intangible asset (like a patent or software) over its useful life. It is the intangible-asset version of depreciation, and it is also non-cash.
- Inventory
- The goods a company has made or bought but not yet sold. It is a current asset, and cash stays locked up in it until it is sold.
Frequently asked
- Depreciation goes up by $20, walk me through the three statements.
- At a 40% tax rate: on the income statement, pre-tax income falls $20 and taxes fall $8, so net income falls $12. On the cash flow statement you start at net income down $12 and add back the full $20 of depreciation because it is non-cash, so cash rises $8. On the balance sheet, cash is up $8 and PP&E is down $20, so assets fall $12, and retained earnings falls $12. It balances.
- If depreciation is a non-cash expense, why did cash go up?
- Because of the tax shield. No cash ever went out the door for the depreciation itself, so the only thing that actually moved cash was the smaller tax bill. Cash rises by exactly the charge times the tax rate, which is $20 at 40%, or $8. Set the tax rate to zero and cash does not move at all, which is the cleanest proof that tax is the whole cash story.
- What order should you walk the three statements in?
- Income statement, then cash flow statement, then balance sheet, then connect it back to the income statement. The order is not a preference, it is the dependency chain: you cannot start the cash flow statement without net income, and you cannot fill the balance sheet cash line without the cash flow statement. The last step is naming why it balances, which is that net income drove retained earnings.
- Why does the balance sheet balance in a three-statement walk?
- Because net income drove retained earnings. Net income leaves the income statement and lands in two places: the top of the cash flow statement, and retained earnings inside equity. So the asset side and the equity side move by the same figure by construction, not by coincidence. Saying that out loud, rather than just asserting that it balances, is what proves you ran the system instead of reciting a result.
- How do you answer any 'walk me through the impact' question?
- Two questions decide everything. First, did it hit the income statement? If yes, net income moves by the after-tax amount and that is where tax enters. If no, there is no tax effect at all. Second, did cash actually move? A non-cash charge gets added back in full; cash that moved without an income statement hit shows up as a working capital change, in investing, or in financing. The balance sheet is then forced.
- What happens to the three statements when deferred revenue increases by $20?
- Nothing happens on the income statement, because nothing has been earned yet. On the cash flow statement the increase in the deferred revenue liability is a source of cash, so cash rises the full $20. On the balance sheet cash is up $20 and the deferred revenue liability is up $20, so it balances with no change to equity and no tax effect anywhere.
- Does the answer change if the interviewer says $10 or $100 instead of $20?
- No. The number is decoration and the tax rate is whatever you say it is out loud. The mechanism is fixed: net income falls by the after-tax amount, the full charge is added back, and cash rises by the charge times the tax rate. State your tax rate at the start, keep the arithmetic round, and the size of the number never matters.
Make it stick
Drill what you just learned