Walk me through how the three financial statements are linked.
What the interviewer wants to hear
- Net income from the income statement starts the cash flow statement
- Net income less dividends flows into retained earnings on the balance sheet
- Non-cash items and working capital changes adjust profit to operating cash
- Capex and financing flows change fixed assets, debt and equity
- Closing cash on the cash flow statement equals cash on the balance sheet
Model answer
The income statement shows revenue, expenses and net income for a period. Net income is the first line of the cash flow statement under the indirect method. There I add back non-cash items like depreciation and adjust for working capital changes, such as higher receivables using cash, to get operating cash flow. Investing cash flow shows capex and asset sales, and financing cash flow shows debt raised or repaid, equity issued and dividends paid. The net change in cash is added to opening cash, and the closing cash must equal the cash line on the balance sheet. On the balance sheet itself, retained earnings increase by net income less dividends, fixed assets increase by capex and fall by depreciation, and debt moves with borrowings and repayments. If the balance sheet balances after these links, the model is usually wired correctly.
Can you answer it under time pressure?
Take a timed easy round and get scored on every answer.
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