The Three Financial Statements: How They Link and How to Explain It

Amazon reported a net loss of $241 million for 2014 and still brought in $6.8 billion of cash from operations, and the links between the three financial statements explain that gap. The three statements link through net income and ending cash. Net income ends the income statement, starts the cash flow statement, and adds to retained earnings on the balance sheet, and ending cash is the number the cash flow statement hands to the balance sheet. Every other link is the cash flow statement turning a change on the balance sheet into cash.

I'm Stephen Turban, founder of WSG. I went to Harvard and worked at McKinsey, and I've run a lot of mock technical interviews with students headed into banking. The classic interview version is one question, "Depreciation goes up by $10. Walk me through the three statements," and Wall Street Prep includes it in its list of the ten most commonly asked accounting questions. By the end of this guide you'll be able to answer it, handle the follow-ups that test each link, and tie out a full year of statements.

How the Three Statements Connect

Each statement answers a different question, and you need all three because no single one shows both profit and cash.

• Income statement: did the company make money over the period? It runs from revenue down to net income, and it uses accrual accounting, so revenue counts when it's earned and costs count when they're incurred, whether or not any cash has moved.

• Balance sheet: what does the company own and owe on one date? Assets sit on one side and liabilities plus shareholders' equity on the other, and the two sides are always equal.

• Cash flow statement: where did the cash actually go over the period? It starts with net income and corrects it, line by line, until it reaches the real change in cash, in three sections: operating, investing, and financing.

The cash flow statement exists because of that accrual gap. Say a company buys a machine for $100 in cash. The cash leaves on the day of purchase, but the income statement doesn't take the whole $100 as an expense that year. It charges a slice each year as depreciation, over the years the machine is used. So the income statement shows an expense in years when no cash moves, and the cash flow statement's job is to undo that and show the cash.

Six connections cover the links that most three-statement interview questions test, so once you know them, you can reason through a scenario you've never seen.

Item	Income statement	Cash flow statement	Balance sheet
Net income	Bottom line	Top line of the operating section	Added to retained earnings, minus any dividends
Depreciation and amortization (D&A)	Expense that lowers profit	Added back, because no cash left this period	Lowers net PP&E (and intangibles, for amortization)
Working capital: receivables, inventory, payables	Not here	An asset going up is cash out; a liability going up is cash in	The year-over-year change in each line
Capital expenditures (capex)	Not here; reaches it later through depreciation	Outflow in investing	Raises net PP&E
Debt	Interest expense only	Borrowing or repayment in financing	The debt balance
Ending cash	Not here	The last line	The cash line

Capex and depreciation are mirror images: capex is cash going out with no expense yet, and depreciation is an expense with no cash going out, which is why net PP&E rises by capex and falls by depreciation each year. For working capital, apply the table's sign rule: receivables that grow by 10 mean 10 of revenue hasn't been collected yet, and the cash flow statement subtracts it.

Why the Balance Sheet Always Balances

The balance sheet balances because every transaction keeps both sides equal: it either changes both sides by the same amount or moves value between lines on the same side, so a balance sheet that doesn't balance means a link was missed or a sign was flipped. Spend cash on a machine and cash falls while PP&E rises, two assets with the total unchanged. Borrow and cash rises along with debt, so both sides go up. Pay a dividend and cash falls along with retained earnings, so both sides go down. No transaction changes one side's total without changing the other's, which is why a good walk ends with "so it balances."

Walk the Statements in This Order: Income Statement, Cash Flow Statement, Balance Sheet

Walk the income statement first, the cash flow statement second, and the balance sheet last, because each statement hands the next one the number it needs. The income statement produces net income, the first line of the cash flow statement. The cash flow statement produces the change in cash, which you need for the cash line on the balance sheet. By the time you reach the balance sheet you know cash, PP&E, and retained earnings, so you can finish by checking that both sides moved by the same amount. Some guides walk the balance sheet second, and either order reaches the same answer, but finishing on the balance sheet means you never have to guess the cash line before you've worked it out.

Each box ends with the number the next box starts from, and the balance sheet ends with the check.

When an interviewer asks the broad version, "Walk me through the three statements," a spoken answer like this one names the links in about a minute:

"The income statement covers a period. It goes from revenue through cost of goods sold, operating expenses, and depreciation to operating income, then interest and taxes, to net income, and it records revenue when it's earned and costs when they're incurred. The cash flow statement starts from that net income, adds back non-cash expenses like depreciation, adjusts for changes in working capital, then shows investing and financing activity, and ends with the change in cash. The balance sheet shows assets, liabilities, and equity at a point in time. It connects in three places: ending cash from the cash flow statement is the cash line, net income minus dividends goes into retained earnings, and capex and depreciation change PP&E. If every link is right, the balance sheet balances."

Walk Me Through $10 of Depreciation

At a 25 percent tax rate, $10 of depreciation lowers net income by 7.5 and raises cash by 2.5, and it lowers both total assets and total liabilities and equity by 7.5. Say the tax rate before you start, since every number after it depends on that assumption. In the table, parentheses mean the line went down.

Statement	Line	Change
Income statement	Depreciation expense	+10
Pre-tax income	(10)
Taxes at 25%	(2.5)
Net income	(7.5)
Cash flow statement	Net income	(7.5)
Add back depreciation	+10
Net change in cash	+2.5
Balance sheet	Cash	+2.5
Net PP&E	(10)
Total assets	(7.5)
Retained earnings	(7.5)
Total liabilities and equity	(7.5)

Income statement: depreciation is an expense, so pre-tax income falls by 10. The company owes tax on 10 less profit, so at 25 percent its taxes fall by 2.5, and net income falls by 7.5.

Cash flow statement: start with net income, which is 7.5 lower, then add back the 10 of depreciation because it didn't use any cash this year. Cash from operations, and the net change in cash, is up 2.5.

Balance sheet: cash is up 2.5 and net PP&E is down 10, so total assets are down 7.5. On the other side, retained earnings fall by the 7.5 drop in net income, so liabilities and equity are down 7.5 too, and it balances.

The part worth getting right is why cash goes up when depreciation is called a non-cash expense. It helps to keep three things apart. The accounting entry is an expense on the income statement and a matching cut to the book value of PP&E on the balance sheet. The expense is non-cash because the cash went out when the machine was bought, in an earlier year, so nothing is paid this year. The cash effect comes from taxes: depreciation is tax deductible, so the company's tax bill is 2.5 lower, and that saving is real cash. The 2.5 is the 10 of depreciation times the 25 percent rate, which bankers call the tax shield. The add-back on the cash flow statement is how that shows up; the tax saving is why cash rises at all. The walk assumes, as interview answers usually do, that depreciation is the same for taxes as on the income statement and that taxes are paid in cash this year.

You may be given a 40 percent rate instead, which gives net income down 6 and cash up 4. That round number fit the years when the top federal corporate rate was 35 percent and state taxes pushed the combined rate to about 39 percent. The 2017 Tax Cuts and Jobs Act cut the federal rate to a flat 21 percent, and the Tax Foundation puts the average combined federal and state rate at 25.5 percent for 2026, so 25 percent is the closer round number today. Either rate is fine in an interview as long as you say which one you're using. Depreciation can sit on its own line or inside cost of goods sold or operating expenses (Wall Street Prep notes companies seldom show it separately), and wherever it sits, it lowers pre-tax income the same way.

Six Follow-Up Scenarios and the Link Each One Tests

Each common follow-up tests a different link: working capital moves cash against another balance sheet line, capex moves cash into PP&E, debt moves cash and a liability together, and an accrual is an expense with no cash out yet. All six use the same 25 percent tax rate.

Scenario	Income statement	Cash flow statement	Balance sheet
Inventory up $10, paid in cash	No change	Operations (10)	Inventory +10, cash (10)
Inventory up $10, bought on credit	No change	Inventory (10) and payables +10, so cash is unchanged	Inventory +10; payables +10
$100 of capex, paid in cash	No change this year	Investing (100)	PP&E +100, cash (100)
Borrow $100	No change until interest is charged	Financing +100	Cash +100; debt +100
$10 of wages owed but not yet paid	Net income (7.5)	Net income (7.5), accrued expenses +10, cash +2.5	Cash +2.5; accrued expenses +10, retained earnings (7.5)

Inventory, paid in cash or on credit: buying inventory never touches the income statement, because inventory becomes an expense only when it's sold, through cost of goods sold. Paid in cash, an operating asset went up, so cash goes down by 10 and total assets don't change. Bought on credit, payables rise by the same 10 and cancel the cash effect. The pair shows that working capital questions come down to who has paid whom.

Capex: the 100 leaves through investing and reappears as PP&E, so total assets don't change and the income statement doesn't see it until depreciation starts. The usual follow-up is "Now go out a year," and if the machine depreciates over ten years, next year is the $10 depreciation walk above.

Borrowing: the principal moves only cash and debt. The interest is what reaches the income statement: at 5 percent, next year's interest of 5 lowers net income by 3.75, and cash falls by 3.75 too, because interest, unlike depreciation, is paid in cash.

Wages owed but not yet paid: net income and cash move by the same amounts as in the depreciation walk, because in both cases the income statement records a cost with no cash out this year, and cash rises by the 2.5 of tax saved. The balance sheet is where they differ. Depreciation's offset is an asset going down (PP&E), so both sides fall by 7.5; the accrual's offset is a liability going up (accrued expenses), so both sides rise by 2.5. When the wages are paid, accrued expenses and cash both fall by 10 with no income statement effect.

The sixth scenario reverses the depreciation logic: a company sells equipment with a book value of 30 for 40 in cash, so the income statement records a gain that isn't operating cash.

Statement	Line	Change
Income statement	Gain on sale	+10
Taxes at 25%	+2.5
Net income	+7.5
Cash flow statement	Net income	+7.5
Subtract gain on sale	(10)
Cash from operations	(2.5)
Proceeds from sale (investing)	+40
Net change in cash	+37.5
Balance sheet	Cash	+37.5
Net PP&E	(30)
Total assets	+7.5
Retained earnings	+7.5
Total liabilities and equity	+7.5

The gain on a sale is subtracted from operating cash flow because the full sale price already shows up in investing, and counting the gain in operations too would count it twice. The income statement records a gain of 10, the price minus the book value, and net income rises by 7.5 after tax. On the cash flow statement, the gain comes out of operations, which leaves operations at negative 2.5, the tax paid on the gain. The whole 40 of proceeds then shows up in investing, so cash rises by 37.5. On the balance sheet, cash is up 37.5 and the machine's 30 of book value is gone, so assets are up 7.5, matching the 7.5 rise in retained earnings.

A write-down of an asset walks the same way as depreciation, just as one larger amount, if you treat it as tax deductible; its tax treatment can differ in practice, so say which assumption you're using, the same way you state the tax rate. WSG's 50 accounting interview questions post has more scenarios to drill once these six feel automatic.

A Full Year: How Lantern Bikes' Statements Tie

The scenarios test one link at a time, and a full year shows all six moving together. Lantern Bikes is a made-up maker of commuter bicycles, going from the end of Year 1 to the end of Year 2. Figures are in $ millions, and the tax rate is 25 percent.

Its Year 2 income statement is short. Revenue of 500, minus 300 of cost of goods sold, 100 of selling, general, and administrative costs, and 30 of D&A, leaves 70 of operating income. Interest is 10, which is 5 percent on the 200 of debt Lantern Bikes started the year with, so pre-tax income is 60, taxes are 15, and net income is 45.

Lantern Bikes' Year 2 cash flow statement:

Line	Year 2	Link
Net income	45	From the income statement
Plus: D&A	30	Non-cash, added back
Less: increase in accounts receivable	(10)	Receivables 60 to 70
Less: increase in inventory	(5)	Inventory 80 to 85
Plus: increase in accounts payable	6	Payables 50 to 56
Plus: increase in accrued expenses	2	Accrued expenses 20 to 22
Cash from operations	68
Capex	(40)	Raises PP&E
Debt repaid	(20)	Debt 200 to 180
Dividends paid	(12)	Lowers retained earnings
Net change in cash	(4)
Beginning cash	40	Year 1 balance sheet
Ending cash	36	Becomes balance sheet cash

Lantern Bikes' balance sheet, Year 1 to Year 2:

Line	Year 1	Year 2	Change	Why
Cash	40	36	(4)	Ending cash from the cash flow statement
Accounts receivable	60	70	10	Working capital
Inventory	80	85	5	Working capital
Net PP&E	300	310	10	Plus capex of 40, minus D&A of 30
Total assets	480	501	21
Accounts payable	50	56	6	Working capital
Accrued expenses	20	22	2	Working capital
Long-term debt	200	180	(20)	Repaid 20
Common stock	100	100	0	No shares issued or bought back
Retained earnings	110	143	33	Plus net income of 45, minus dividends of 12
Total liabilities and equity	480	501	21

Lantern Bikes earned 45 in Year 2 and still ended the year with 4 less cash, because capex, the debt repayment, the dividend, and the working capital build took out more cash than profit and the depreciation add-back brought in. That's the gap between profit and cash that the cash flow statement exists to show, and the chart below walks it from beginning cash to ending cash.

Profit and the depreciation add-back lift cash from 40 to 115, and working capital, capex, the debt repayment, and the dividend bring it down to 36.

The balance check closes the year. Assets rose by 21, and liabilities plus equity rose by 21: liabilities fell by 12 (payables up 6, accrued expenses up 2, debt down 20), and equity rose by 33. If you changed any one number without its partner, such as repaying debt without taking the cash out, the check would be off by exactly that amount, which is how you'd find the error in a model.

Follow-Up Questions That Test Whether You Understand the Links

"Can a company have positive net income and negative cash flow?" A company can report a profit while its cash falls, often because working capital grows or capex is heavy. Lantern Bikes just did it, and a company that sells on credit sees the same effect as its receivables rise. The reverse happens too: Amazon reported a net loss of $241 million for 2014 and $6.8 billion of cash from operations, and its $4.7 billion of depreciation and amortization, added back on the cash flow statement, explains most of that gap.

"If you could only have one statement, which would you pick?" If you could keep only one statement, the usual pick is the cash flow statement, because it shows how much cash the business actually generates, and a company fails when it runs out of cash. The common follow-up is "What if you could have two?" The answer is the income statement and the balance sheet, because together they hold everything you need to rebuild the cash flow statement: net income and the non-cash items from the income statement, and every working capital, capex, and debt move from the change in the balance sheet.

The same links reappear in valuation. Unlevered free cash flow in a DCF starts from after-tax operating income, adds back D&A, subtracts capex, and adjusts for working capital, which are links you've just walked; WSG's walk me through a DCF guide picks up from there.