FinanceFluency
Accounting
Accounting

How the three statements link together

The classic $10 of depreciation question, explained so you never forget it.

Before we dive in, here's the mental model you should hold in your head the entire time — every transaction traces through these two arrows and nothing else:

Income StatementRevenue → Net IncomeCash Flow StatementNet Income → Δ CashBalance SheetA = L + ENet IncomeΔ CashNet Income → Retained Earnings
The two canonical links: Net Income flows to CFS and to Retained Earnings; Δ Cash flows to the Balance Sheet.

Once you can walk through the three statements, interviewers immediately test whether you actually understand them by asking you to trace a single transaction across all three. The classic version:

"If depreciation goes up by $10, walk me through how it affects the three statements. Assume a 40% tax rate."

This is a weeding question. Getting it right is table stakes. Let's break it down.

The answer

Income statement

  • Depreciation is an operating expense, so operating income falls by $10.
  • At a 40% tax rate, taxes fall by $4.
  • Net income falls by $6 ($10 × (1 − 40%)).

Cash flow statement

  • Start with net income: −$6.
  • Add back depreciation (a non-cash charge): +$10.
  • Net change in cash from operations: +$4.
  • Cash from investing and financing are unaffected.
  • Cash at the bottom of CFS: +$4.

Balance sheet

Assets side:

  • Cash: +$4 (from the CFS).
  • PP&E (net of accumulated depreciation): −$10.
  • Total assets: −$6.

Liabilities + equity side:

  • Retained earnings: −$6 (net income flows to equity).
  • Total L+E: −$6.

Both sides fall by $6. The balance sheet balances. ✅

Say this out loud until it's automatic

Income statement: operating income down $10, taxes down $4, net income down $6. Cash flow statement: start with NI down $6, add back D&A of $10, cash up $4. Balance sheet: cash up $4, PP&E down $10, so assets down $6; retained earnings down $6, so equity down $6; balances.

Why each step happens

The three statements are stitched together by exactly two links:

  1. Net income from the income statement flows into:

    • The top of the cash flow statement (as the starting point).
    • Retained earnings on the balance sheet (net income − dividends).

  2. Cash from the bottom of the cash flow statement flows into the balance sheet's cash line.

Any change on the income statement must be traced through these two links. If you forget one, your balance sheet won't balance.

Variations you will see

Interviewers love to ramp this up. Expect any of:

  • "Inventory goes up by $10 paid for in cash." → no IS impact, CFS: operating cash −$10, BS: inventory +$10, cash −$10.
  • "The company buys a $100 machine with $50 cash and $50 debt." → no IS impact, CFS: investing −$100, financing +$50, BS: PP&E +$100, cash −$50, debt +$50.
  • "Accrued expenses rise by $10." → IS: expenses +$10, NI falls by $6, CFS: NI −$6, add back ΔAccrued +$10, net +$4, BS: cash +$4, accrued +$10, RE −$6, balances.

The framework is always the same:

  1. Does this change the income statement? If so, what happens to net income?
  2. Does this change cash? Trace it through the CFS.
  3. What does the balance sheet look like when both are done? Does it balance?

Common traps

  • Forgetting taxes. Every income statement change is multiplied by (1 − tax rate) before it hits net income.
  • Double-counting depreciation. It reduces net income and is added back on the CFS. Both happen. That's the whole point.
  • Panicking when the BS doesn't balance. It always balances. If yours doesn't, check retained earnings — that's where 90% of mistakes live.

What you should be able to do after this lesson

  • Walk through the $10 depreciation question cold.
  • Apply the same framework to any one-line transaction an interviewer throws at you.
  • State both links (NI → CFS + retained earnings, cash → balance sheet) from memory.