Three-Statement Modeling

This is, honestly, the single most commonly failed technical question in real banking interviews — not because it's conceptually hard, but because most candidates have only ever seen the three statements separately, never watched them actually move together. Everything from here to the end of this course (M&A, valuation, reading a real deal) leans on this linkage, so it's worth building properly now.

The three statements, in one sentence each

• Income statement: how much money the company made this period (revenue down to net income) — a flow over time.
• Balance sheet: what the company owns and owes at one specific moment — a snapshot, not a flow.
• Cash flow statement: where the company's actual cash came from and went during the period — because net income (an accounting figure, full of non-cash items and timing assumptions) is not the same thing as cash in the bank.

The classic interview question: "Walk me through what happens to the three statements if depreciation increases by $10"

1. Income statement: Depreciation is an operating expense, so a $10 increase reduces operating income (EBIT) by $10. Assume a 25% tax rate: pre-tax income falls by $10, taxes owed fall by $10 × 25% = $2.50. Net income falls by $10 − $2.50 = $7.50.

2. Cash flow statement: Start with net income (down $7.50). But depreciation is a non-cash expense — no actual $10 left the building. So you add depreciation back: −$7.50 + $10 = cash flow from operations is actually UP $2.50. This is the single most counter-intuitive part of the exercise: an expense that reduces accounting profit can increase real cash — because the tax savings from that non-cash deduction ($2.50) is real cash the company didn't have to pay to the government.

3. Balance sheet: Cash is up $2.50 → assets up $2.50 from that. Accumulated depreciation is up $10, reducing net PP&E by $10 → assets down $10 from that. Net effect on assets: +$2.50 − $10 = down $7.50. Retained earnings (equity) falls by the $7.50 drop in net income → equity down $7.50. Assets down $7.50, liabilities+equity down $7.50 — the balance sheet still balances. If your walk-through doesn't end with the balance sheet balancing, something in your logic was wrong.

Why this matters more than memorizing the mechanic

An interviewer doesn't care whether you can recite "depreciation is added back" — every prep book says that. What's being tested is whether you understand why, well enough to handle a variant you haven't memorized: What if it's an increase in accounts receivable instead? (Net income unaffected, but cash flow from operations falls — you booked the sale as revenue, but haven't collected the cash yet.) A stock buyback funded by new debt? (Cash out and treasury stock up on the equity side — reducing equity — debt up on liabilities, cash swings through financing activities, not operations.)

The skill is tracing any transaction through all three statements from first principles — not three memorized answers for three memorized questions.

The five words that make this teachable: "where did the cash go"

Every cash flow statement line item answers one question: for this specific change, where did the actual cash go (or come from), and does that match what the income statement or balance sheet implied? If revenue went up but a receivable also went up by the same amount, the cash hasn't arrived yet. If an expense was booked but no cash left the building, add it back — the income statement charged you for something that isn't a real cash outflow this period.