In this article
Before you start
For the rest of the round's technical questions, see the investment banking interview guide.
Why interviewers ask this
A walkthrough shows within a minute whether a candidate understands the accounting or only memorised a diagram. One small change must touch every statement in the right direction, and a wrong cash line gives it away.
Practitioner guides such as ibinterviewquestions.com treat the walkthrough as a standard question, and candidates report it in finance interviews. This page does not claim how often any firm asks it.
A weak answer lists the three statements and says they are "linked". A strong answer names the link, net income, then moves one number through each statement and checks the balance. The strongest answer also says which part is accounting convention and which part is cash, and can change the tax rate on request and re-run the walk without notes.
Three-statement walkthrough from first principles
- Tax shield
- A tax shield is a reduction in the tax a company pays that comes from a deductible expense, so the expense lowers cash taxes by the expense multiplied by the tax rate. Depreciation is the standard example: it costs no cash itself, but it lowers taxable income, and that is the only way it changes cash in a three-statement walk.
- Non-cash expense
- A non-cash expense is a cost recorded on the income statement that does not move cash in the period it is recorded. Depreciation is the usual example: the cash left the business earlier, when the asset was bought, and that purchase sits in investing activities on the cash flow statement (Wall Street Prep, accessed 2026-10-26).
In plain words
Think of your own money. A payslip says what you earned, a bank statement says what cash moved, and a net-worth list says what you own and owe. They describe one life in three ways. The analogy breaks in one place: a company records a cost when it is incurred, not when the cash leaves, so the first and second documents can disagree for a while.
In one sentence, the income statement measures profit, the cash flow statement explains why cash moved, and the balance sheet is the snapshot that must stay in balance after both.
Retained earnings is the running total of a company's past net income that has not been paid out, and it sits in the equity section of the balance sheet. Capex is cash spent on long-lived assets such as equipment. The walkthrough uses one small change: a depreciation expense. The numbers below are illustrative, and the script behind them is named in the worked example.1
Step 1: The income statement takes the expense
Depreciation is an expense, so it lowers pre-tax income. Tax is charged on a smaller profit, so tax expense falls too. Net income falls by the depreciation times one minus the tax rate.
Take ten dollars of depreciation at a forty percent tax rate. Pre-tax income falls by ten, tax falls by four and net income falls by six. A practitioner walk gives the same figures: pre-tax income falls by 10 and net income by 6 at a 40% tax rate. Input: the expense and the tax rate. Output: a lower net income. Nothing has touched cash yet, and the next step carries that net income onward.
Step 2: Net income flows into retained earnings
Net income flows into retained earnings on the balance sheet, and it is also the starting line of the cash flow statement (ibinterviewquestions.com, accessed 2026-10-26). Retained earnings, which sit in equity, fall by six in the example. Dividends would also reduce them, but this walk has none.
The other side of the balance sheet needs a matching move. Depreciation reduces the book value of the asset, so net property, plant and equipment (PPE) falls by ten. Equity is down six and one asset is down ten, so a four-dollar gap remains until cash is updated. Input: net income. Output: lower retained earnings and lower net PPE, plus a gap that only the cash flow statement can fill.
Step 3: The cash flow statement adds depreciation back, and only the tax saving remains
The cash flow statement starts from net income and adds depreciation back, because depreciation is a non-cash expense. The statement is designed to describe the sources and uses of cash and to reconcile net income to net cash flows from operating activities (Klynveld Peat Marwick Goerdeler (KPMG), February 2023).
Start from net income, down six, and add back the ten of depreciation: cash from operations rises by four. That four is not created by the add-back. The add-back only reverses a deduction that never used cash. The four is the tax saved, because taxable income was lower. Cash change equals depreciation times the tax rate, ten times forty percent. The real cash outflow happened earlier, when the asset was bought, and it sits in investing.
Step 4: The balance sheet picks up the cash and balances
Ending cash from the cash flow statement becomes cash on the balance sheet, and assets then equal liabilities plus equity. Cash rises by four and net PPE falls by ten, so assets and equity both fall by six. Retained earnings fall by six and liabilities do not move.
That final check is the point of the walk. A balance sheet that only needs cash to tie is not enough: every flow-through must balance across assets, liabilities and equity. State the check out loud. If the two sides differ, a step was missed, usually the add-back or the PPE reduction. Recheck each step in order before you speak.
Step-by-step description
- Depreciation lowers pre-tax income and net income.
- Retained earnings fall by 6 and net PP&E falls by 10.
- Start from net income and add depreciation back.
- Cash +4 and PP&E -10 leave assets -6, equal to equity -6.
- Depreciation lowers pre-tax income, and net income falls by the depreciation times one minus the tax rate.
- Net income flows into retained earnings on the balance sheet, and net PP&E falls by ten.
- The cash flow statement starts from net income and adds depreciation back.
- Cash rises by four and net PP&E falls by ten, so assets and equity both fall by six.
How are the three statements linked? The 60-second walkthrough
A walkthrough of the three statements runs from the top line to the bottom line in one pass. The income statement shows revenue less expenses and ends in net income, the profit for the period. The cash flow statement starts from net income, adjusts for non-cash items and working-capital changes to reach cash from operations, then adds investing and financing cash flows to give the change in cash.
The balance sheet is the snapshot at a date: assets, liabilities and equity, with cash taken from the cash flow statement and retained earnings rolled forward by net income less dividends. Net income links the first two statements into the balance sheet, and cash links the cash flow statement into it. Finish by saying that assets equal liabilities plus equity, then offer to trace one change through all three.
Knowing it is half the job. Saying it is the other half.
Interview Clozo is an AI interview copilot for real interview rounds: it hears the question and puts a strong answer on your screen, and you say it in your own words. See the features or how it works.
Start Free Trial →Worked example
A company records ten dollars of depreciation at a forty percent tax rate. All figures below are illustrative and computed, not reported.1
| Line | Change at 40% tax |
|---|---|
| Pre-tax income | -10 |
| Income tax expense | -4 |
| Net income | -6 |
| Add back depreciation | +10 |
| Cash from operations | +4 |
| Net PPE | -10 |
| Total assets | -6 |
| Retained earnings | -6 |
| Assets minus liabilities and equity | 0 |
Change the tax rate and the walk changes only in the tax line. At 25%, net income falls by 7.50 and cash rises by 2.50. At 0%, net income falls by 10, cash does not move, net PPE falls by 10 and retained earnings fall by 10.1 In the illustrative case of a depreciation expense of 10, cash changes by 0, 2.5 and 4 at tax rates of 0%, 25% and 40%. The rule is that the cash change equals depreciation times the tax rate.
Text description of the diagram
- In the illustrative case of a depreciation expense of 10, cash changes by 0, 2.5 and 4 at tax rates of 0%, 25% and 40%.
- The cash change equals depreciation times the tax rate.
Now a purchase. Capex of 100 is an investing outflow: cash falls by 100 and PPE rises by 100, so total assets are unchanged and the income statement is untouched at the time of purchase. Wall Street Prep places capex in investing activities, and the figures are recomputed here.1 Depreciation reaches the income statement only in later periods, which is why the two examples are separate walks.
Four more walks use the same illustrative approach. The assumptions are that taxes are paid in cash and that tax depreciation equals book depreciation, so a deductible expense lowers cash taxes by the expense times the 40% rate.1
| Walk | Income statement | Cash flow statement | Balance sheet |
|---|---|---|---|
| Buy 10 of inventory with cash | No change | Operations -10 | Cash -10, inventory +10, assets 0 |
| Raise 100 of debt (no interest) | No change | Financing +100 | Cash +100, debt +100 |
| Accounts receivable up 10 | No change | Operations -10 | Cash -10, receivables +10, assets 0 |
| Write an asset down by 10 | Pre-tax -10, tax -4, net income -6 | Add back 10, operations +4 | Asset -10, cash +4, retained earnings -6 |
Trade-offs and edge cases
Direct or indirect. The cash flow statement can be presented two ways. The Accounting Standards Codification (ASC) topic 230 allows either method and encourages the direct method (PwC Viewpoint, accessed 2026-10-26); the Codification is the US rule book. In practice the indirect method is the more common presentation. Both report the same net operating cash flow, and a reconciliation from net income is required either way (KPMG, February 2023).
Reconciliation lines are adjustments. There is no prescribed format for the reconciliation, and its line items are adjustments to net income rather than cash flows themselves. It starts from net income, the starting point for reconciling operating cash flows (PwC Viewpoint, accessed 2026-10-26). Interest and income taxes paid are disclosed separately (KPMG, February 2023).
Convention, not a standard. The inventory, debt, receivables and write-down walks follow practitioner convention rather than a rule in the sources above. The illustrative walks in the worked example compute them under two assumptions: taxes are paid in cash, and tax depreciation equals book depreciation. A rise in receivables or inventory uses operating cash, debt raised is a financing inflow, and a write-down behaves like depreciation. State your assumptions out loud.1
Framework. This page follows US generally accepted accounting principles (GAAP) guidance. International Financial Reporting Standards (IFRS) are the main alternative framework and can classify some items differently, so say which one you assume. For modelling follow-ups, see financial modeling interview questions, and for valuation, how to walk through a discounted cash flow (DCF).
Text description of the diagram
- Depreciation is an expense, then an add-back, then a lower asset value.
- Capex is an investing outflow that never touches the income statement at purchase.
Depreciation is an expense, then an add-back, then a lower asset value. Capex is an investing outflow that never touches the income statement at purchase.
How to answer it in an interview
Walk me through what happens to the three statements if depreciation goes up.
Say I record ten dollars of depreciation at a forty percent tax rate. On the income statement, pre-tax income falls by ten and net income falls by six. On the cash flow statement I start from net income, down six, and add back the ten because depreciation is non-cash, so cash from operations rises by four. That four is the tax saved. On the balance sheet, cash is up four and net property, plant and equipment is down ten, so assets fall by six. Retained earnings fall by six through net income, so both sides move together and it balances. If tax were zero, cash would not move at all.
The spoken structure: pick the numbers, go statement by statement in order, name the tax saving, then state the balance check. The figures in this answer match the illustrative walk above.1
Common mistakes
- "Depreciation is a cash cost." (wrong) It is non-cash and is added back. (right) "Depreciation reduces profit and taxes, but no cash leaves when it is recorded."
- "Adding back depreciation increases cash." (wrong) The add-back reverses a non-cash deduction. (right) "Cash rises only because lower profit means lower tax."
- "The balance sheet balances if cash ties." (wrong) Every flow-through must balance across assets, liabilities and equity. (right) "I check assets against liabilities plus equity after each change."
- "Capex hits the income statement immediately." (wrong) It is an investing outflow. (right) "Capex lifts PPE now, and depreciation reaches the income statement in later periods."
Follow-up questions
How do you walk through the three financial statements?
Name the three, state that net income links them, then trace one change through each in order and finish with the balance check, as in the worked example. For wider technical practice use investment banking technical questions and answers.
What happens to the three statements if inventory is bought with cash?
Cash falls by 10 and inventory rises by 10, so total assets do not change and the income statement does not move (illustrative).1 On the cash flow statement the inventory increase reduces cash from operations by 10.
What happens to the three statements if the company raises debt?
Debt raised is a financing inflow: cash from financing rises by 100, cash rises by 100 and debt rises by 100, with no immediate income statement effect when interest is ignored (illustrative).1
What happens to the three statements if accounts receivable increases?
The revenue is already in net income but the cash has not arrived, so the rise in receivables reduces cash from operations by 10 and total assets do not change (illustrative).1
What happens to the three statements if an asset is written down?
A write-down of 10 behaves like depreciation when taxes are paid in cash and the tax deduction equals the book charge: net income falls by 6, operations rise by 4 after the add-back, and the asset falls by 10 (illustrative).1
Does the walkthrough change in an acquisition?
The same discipline applies: every change moves all three statements and the balance sheet must balance. Deal-specific adjustments are covered in mergers and acquisitions questions and answers.
- Net income links the three statements: it feeds retained earnings and starts the cash flow statement.
- Depreciation is non-cash, so it is added back, and cash rises only by the tax saved.
- Cash change from depreciation equals depreciation times the tax rate.
- Capex is an investing outflow, with cash down and PPE up by the same amount.
- Always finish a walkthrough by checking that assets equal liabilities plus equity.
Sources
- Statement of cash flows handbook (US GAAP) — KPMG US (document dated February 2023; accessed 2026-10-26), 1 Feb 2023
- Statement of Cash Flows Under ASC 230 (Blueprint) — BDO USA (document dated December 2025; accessed 2026-10-26), 1 Dec 2025
- 6.4 Format of the statement of cash flows — PwC Viewpoint (undated; accessed 2026-10-26), 26 Oct 2026
- How are the Three Financial Statements Linked? — Wall Street Prep (practitioner; accessed 2026-10-26), 26 Oct 2026
- Walk Me Through the Three Financial Statements — ibinterviewquestions.com (practitioner; accessed 2026-10-26), 16 May 2026
