Varieties of this question are some of the most common technical question asked in interviews today. This type of question attempts to test your understanding of how the three financial statements (income statement, balance sheet, cash flow statement) fit together. The most common variation of this question is how does $10 of depreciation affect the three financial statements (answered below). I’ve posted a few additional examples as well.
To answer this question, take the 3 statements one at a time. My advice is to start with the income statement. Remember to tax-affect any change in revenue or costs (usually you will be told to assume a tax rate of 40%). Work your way down to net income. Next, tackle the cash flow statement. The first line of the cash flow statement is net income so start with that and work your way down to net change in cash. Last, take the balance sheet. The first line of the balance sheet is cash so again, start with that. The balance sheet must balance in order for your answer to be correct, which is why I recommend doing the balance sheet last. Remember the basic balance sheet equation: Assets = Liabilities + Shareholders’ Equity.
Don’t get too stressed when asked a question like this. Just take it slowly, one statement at a time.
The most common version of this type of question. Note that the amount of depreciation may be a number other than $10. To answer this question, take the three statements one at a time.
First, the income statement: depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder’s equity decreased $6.
You may get the follow-up question: If depreciation is non-cash, explain how this transaction caused cash to increase $4. The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.
First Year: Let’s assume that the company’s fiscal year ends Dec. 31. The relevance of the purchase date is that we will assume no depreciation the first year. Income Statement: A purchase of equipment is considered a capital expenditure which does not impact earnings. Further, since we are assuming no depreciation, there is no impact to net income, thus no impact to the income statement. Cash Flow Statement: No change to net income so no change to cash flow from operations. However we’ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. No change in cash flow from financing (since this is a cash purchase) so the net effect is a use of cash of $100. Balance Sheet: Cash (asset) down $100 and PP&E (asset) up $100 so no net change to the left side of the balance sheet and no change to the right side. We are balanced.
Second Year: Here let’s assume straightline depreciation over 5 years and a 40% tax rate. Income Statement: Just like the previous question: $20 of depreciation, which results in a $12 reduction to net income. Cash Flow Statement: Net income down $12 and depreciation up $20. No change to cash flow from investing or financing activities. Net effect is cash up $8. Balance Sheet: Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet doen $12. Retained earnings (shareholders’ equity) down $12 and again, we are balanced.
First Year: Income Statement: No depreciation and no interest expense so no change. Cash Flow Statement: No change to net income so no change to cash flow from operations. Just like the previous question, we’ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities. Now, however, in our cash flows from financing section, we’ve got an increase in debt of $100 (source of cash). Net effect is no change to cash. Balance Sheet: No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 so we balance.
Second Year: Same depreciation and tax assumptions as previously. Let’s also assume a 10% interest rate on the debt and no debt amortization. Income Statement: Just like the previous question: $20 of depreciation but now we also have $10 of interest expense. Net result is a $18 reduction to net income ($30 x (1 – 40%)). Cash Flow Statement: Net income down $18 and depreciation up $20. No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities). Net effect is cash up $2. Balance Sheet: Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18. Retained earnings (shareholders’ equity) down $18 and voila, we are balanced.
Now the company must writedown the value of the equipment down to $0. At the beginning of Year 3, the equipment is on the books at $80 after one year’s depreciation. Further, the company must pay back the entire loan. Income statement: The $80 writedown causes net income to decline $48. There is no further depreciation expense and no interest expense. Cash Flow Statement: Net income down $48 but the writedown is non-cash so add $80. Cash flow from financing decreases $100 when we pay back the loan. Net cash is down $68. Balance Sheet: Cash (asset) down $68, PP&E (asset) down $80, Debt (liability) down $100 and Retained Earnings (shareholders’ equity) down $48. Left side of the balance sheet is down $148 and right side is down $148 and we’re good!