How do the three financial statements link together?

Three connections do the work. Net income is the top of the cash flow statement and flows into retained earnings on the balance sheet. Non-cash charges get added back on the cash flow statement. And the cash flow statement's ending cash becomes the balance sheet cash line, at which point the sheet balances.

Walk me through the three statements when depreciation goes up by 10.

Using a 40% tax rate: pre-tax income drops 10, you save 4 in taxes, so net income falls 6. On the cash flow statement, net income is down 6 but you add back the full 10, so cash rises 4. On the balance sheet, cash is up 4, PP&E down 10, retained earnings down 6, and it balances.

In what order should you walk the three statements?

Always the same order: income statement, then cash flow statement, then balance sheet, and finish by stating that the balance sheet balances. That fixed sequence is your safety rail when an interviewer changes one line and asks you to trace it. Practice it out loud until it is a 60-second reflex.

Accounting

Walk me through the three statements

By Michael Song · Wharton MBA · ex-Greenhill · investment banking interview coach

7 min read · updated July 2, 2026

If you take one thing from this entire library, take this: the three statements are one connected system, not three separate reports. Nearly every technical question in a banking interview is, underneath, a test of whether you understand how a change in one statement ripples through the other two. Get this cold and most of accounting falls into place.

Start with what each statement actually answers, from the seat of the person running the company.

Income statement: did we make money this period? Revenue down to net income, on an accrual basis (you book the sale when you earn it, not when cash arrives).
Balance sheet: what do we own and owe right now? A snapshot at a point in time. Assets = Liabilities + Equity, always.
Cash flow statement: where did the cash actually go? It reconciles accrual net income back to the real movement of cash, because profit and cash are not the same thing.

Key insight

The income statement is built on accruals; the business runs on cash. The cash flow statement exists to bridge the two. That single idea is why this question gets asked. A profitable company can still run out of cash, and bankers get paid to see that coming.

The income statement, top to bottom

The income statement runs from sales at the top to profit at the bottom, peeling off a layer of cost at each step. The subtotals along the way each answer a different question.

Revenue less COGS is gross profit; less operating expenses is EBIT; less interest and taxes is net income.

Revenue: the top line, the total value of what you sold in the period.
Cost of goods sold: the direct cost of making those sales. Revenue minus COGS is gross profit, which tells you how much you keep per dollar of sales before overhead.
Operating expenses: overhead like SG&A, R&D, and depreciation. Gross profit minus these is operating income, or EBIT, the profit from the core business before financing and taxes.
Interest and taxes: subtract interest on debt and then taxes, and you reach net income, the bottom line that belongs to shareholders.

The key mental split: everything above EBIT is about the business; interest and taxes below it are about how the business is financed and taxed. That distinction drives half of valuation. Want the full line-by-line? See The income statement.

The balance sheet, both sides

The balance sheet is a snapshot at one instant of everything the company owns and owes. Its iron rule: assets always equal liabilities plus equity. They have to, because every asset was paid for either with borrowed money (a liability) or owners' money (equity).

Everything the company owns (assets) is funded either by what it owes (liabilities) or by owners (equity). The two sides always tie.

Assets: what the company owns, split into current (cash, receivables, inventory, things that turn to cash within a year) and long-term (PP&E, goodwill, intangibles).
Liabilities: what it owes, again split current (payables, accrued expenses, short-term debt) and long-term (bonds, long-term loans).
Equity: the owners' leftover claim, mainly paid-in capital plus retained earnings, the running total of profits kept in the business.

The gap between current assets and current liabilities is working capital, the money tied up just to run day to day. That's a concept you'll reuse constantly. Full walkthrough: The balance sheet.

The cash flow statement, three sections

Net income is an accrual number, so it doesn't equal cash. The cash flow statement starts at net income and adjusts it back to actual cash, in three buckets.

Operating, investing, and financing cash flows sum to the net change in cash, which lands on the balance sheet.

Cash from operations (CFO): start at net income, add back non-cash charges like depreciation, and adjust for changes in working capital. This is the cash the core business actually threw off.
Cash from investing (CFI): cash spent on or received from long-term assets, mostly capital expenditures and acquisitions.
Cash from financing (CFF): cash raised or returned through debt, dividends, and share buybacks.

Add the three and you get the net change in cash, which drops onto the balance sheet as the new cash balance. That's the loop closing. More detail: The cash flow statement.

How they link

Net income flows into the cash flow statement and retained earnings; ending cash lands back on the balance sheet.

Three connections do almost all the work:

Net income is the top line of the cash flow statement (cash from operations) and it flows into retained earnings on the balance sheet.
Non-cash charges (depreciation, amortization, stock comp) get added back on the cash flow statement, because they reduced net income but no cash left the building.
The cash flow statement's ending cash becomes the cash line on the balance sheet, and the balance sheet balances.

The test: "Depreciation goes up by $10"

This is the classic. An interviewer raises depreciation by $10 and asks you to walk all three statements. Use a 40% tax rate and clean round numbers, because there's no calculator in the room.

Income statement. Depreciation is an expense, so pre-tax income drops by $10. At a 40% tax rate you save $4 in taxes, so net income falls by $6.

Cash flow statement. Start at net income, down $6. But depreciation is non-cash, so you add back the full $10. Net effect: cash from operations is up $4, exactly the tax saving. Cash at the bottom rises $4.

Balance sheet. On the assets side: cash +$4, and PP&E −$10 (you depreciated it), so assets are −$6 net. On the other side: net income fell $6, so retained earnings −$6. Both sides move by $6. It balances.

Common mistake

The two ways people blow this: (1) they forget to add the full $10 of depreciation back on the cash flow statement, and (2) they forget the tax shield. Depreciation's only real cash effect is the taxes it saves. Say the tax rate out loud and the numbers fall out: net income −$6, cash +$4, balance sheet down $6 on each side.

Why interviewers love it

It's the perfect filter. In ninety seconds it reveals whether you memorized definitions or actually understand the plumbing, which is the literal job of a first-year analyst building models.

And it is the question they push on hardest, which is why it gets a lesson of its own. For the full treatment, the tax shield that makes cash rise, why the sheet balances (net income drives retained earnings), and the method that solves any line item they throw at you, see depreciation goes up by $20.

Interview tip

Always walk them in the same order: income statement → cash flow statement → balance sheet, and finish by stating that the balance sheet balances. Practice it out loud until it's a 60-second reflex. That fluency, not the arithmetic, is what separates a confident answer from a shaky one 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.
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.
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.
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.
Accrual accounting: Recording a sale when it is earned and a cost when it is incurred, not when the cash actually changes hands. It is why reported profit and cash can differ.
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.
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.
COGS (Cost of Goods Sold): The direct cost of making the things a company sells, such as materials and factory labor. Revenue minus COGS is gross profit.
Gross profit: Revenue minus the direct cost of the goods sold (COGS). It shows how much a company keeps from each sale before paying for overhead, and dividing it by revenue gives the gross margin.
SG&A: Selling, general and administrative expenses. The overhead of running the business, like salaries, marketing, and rent, that is not tied directly to making the product.
Operating income: Profit from the core business after COGS and operating expenses, but before interest and taxes. It is the same thing as EBIT.
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.
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.
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

How do the three financial statements link together?: Three connections do the work. Net income is the top of the cash flow statement and flows into retained earnings on the balance sheet. Non-cash charges get added back on the cash flow statement. And the cash flow statement's ending cash becomes the balance sheet cash line, at which point the sheet balances.
Walk me through the three statements when depreciation goes up by 10.: Using a 40% tax rate: pre-tax income drops 10, you save 4 in taxes, so net income falls 6. On the cash flow statement, net income is down 6 but you add back the full 10, so cash rises 4. On the balance sheet, cash is up 4, PP&E down 10, retained earnings down 6, and it balances.
In what order should you walk the three statements?: Always the same order: income statement, then cash flow statement, then balance sheet, and finish by stating that the balance sheet balances. That fixed sequence is your safety rail when an interviewer changes one line and asks you to trace it. Practice it out loud until it is a 60-second reflex.

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