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mediumFinancial Analyst interview question

Depreciation goes up by 10 and the tax rate is 25%. Walk me through the impact on the three statements.

What the interviewer wants to hear

  • Pre-tax income falls by 10 and net income falls by 7.5
  • Cash flow from operations rises by 2.5 because of lower tax
  • Cash on the balance sheet rises by 2.5
  • Net fixed assets fall by 10 and retained earnings fall by 7.5
  • Both sides of the balance sheet fall by 7.5 and it still balances

Model answer

On the income statement, depreciation is an expense, so pre-tax income falls by 10. At a 25% tax rate, tax falls by 2.5, so net income falls by 7.5. On the cash flow statement, I start with net income down 7.5 and add back the extra depreciation of 10, because it is non-cash. So operating cash flow goes up by 2.5, which is the tax saving. On the balance sheet, cash is up 2.5 and net fixed assets are down 10, so total assets fall by 7.5. On the other side, retained earnings fall by 7.5 because of the lower net income. Assets and equity both fall by 7.5, so the balance sheet still balances. The key idea is that depreciation itself is not cash, but its tax effect is real cash.

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Take a timed medium round and get scored on every answer.

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