Depreciation and the Three Financial Statements

"If depreciation increases by $10, walk me through the three statements." This is the single most asked technical question in investment banking interviews — and the one that separates candidates who understand accounting linkages from those who memorized steps without grasping the logic. Every IB, PE, and corporate finance interview includes some version of this question. This guide covers the complete framework for any change (depreciation, inventory, debt, equity issuance) and the reasoning behind each line item movement.

The setup

Assume a company with:

• Tax rate: 25%
• No interest expense change (unless the question specifies otherwise)
• The change is $10 of additional depreciation expense

The question tests whether you can trace a single P&L change through all three statements while maintaining the balance sheet balance.

Step 1: Income statement

Revenue                           No change
− COGS                            No change
= Gross Profit                    No change
− Operating Expenses              No change
− Depreciation                    −$10 (THE CHANGE)
= EBIT                            −$10
− Interest Expense                No change
= Pre-Tax Income (EBT)            −$10
− Taxes (25%)                     +$2.50 (tax shield: 25% × $10)
= Net Income                        −$7.50

Key insight: depreciation is tax-deductible, so the net income impact is only 75% of the depreciation increase (the tax shield saves $2.50).

Memorize this pattern: $10 more depreciation → Net Income down $7.50 (at 25% tax rate).

At other tax rates:

• 21% tax: NI down $7.90
• 30% tax: NI down $7.00
• 0% tax: NI down $10.00

Always state the tax rate you're assuming.

Step 2: Cash flow statement

Start with net income and adjust for non-cash items:

Net Income                                    −$7.50
+ Depreciation (add back non-cash expense)    +$10.00
± Change in Working Capital                   No change
= Cash Flow from Operations                   +$2.50
− Capex                                       No change
= Free Cash Flow                              +$2.50

Key insight: depreciation is a non-cash expense on the income statement. You add it back on the cash flow statement because no cash actually left the business. The net cash flow impact is only the tax shield (+$2.50) — the company paid $2.50 less in taxes.

This is the counterintuitive result that interviewers test: depreciation increases cash flow (by the tax shield amount), even though it reduces net income.

Step 3: Balance sheet

Both sides must balance. Track each account:

Assets:

Cash:     +$2.50 (from increased CFO)
PP&E:     −$10.00 (accumulated depreciation increases, reducing net PP&E)
Total Assets: −$7.50

Liabilities + Equity:

Liabilities:          No change
Retained Earnings:    −$7.50 (from net income flowing through)
Total L+E:            −$7.50

Balance check: Assets (−$7.50) = Liabilities + Equity (−$7.50) ✓

The complete walkthrough (memorize this)

| Statement | Line Item | Change | |-----------|-----------|--------| | Income Statement | Depreciation | −$10 | | | EBIT | −$10 | | | Taxes | +$2.50 (shield) | | | Net Income | −$7.50 | | Cash Flow | Net Income | −$7.50 | | | + Depreciation | +$10 | | | CFO | +$2.50 | | Balance Sheet | Cash | +$2.50 | | | PP&E (net) | −$10 | | | Retained Earnings | −$7.50 |

Variations interviewers use

Once you know the depreciation framework, apply the same logic to other changes:

Inventory up $10 (cash purchase)

| Statement | Impact | |-----------|--------| | IS: COGS | No change (yet — inventory is an asset, not expensed until sold) | | CFS: Change in NWC | −$10 (inventory increase = cash outflow) | | BS: Inventory | +$10 | | BS: Cash | −$10 |

Issue $100 of debt

| Statement | Impact | |-----------|--------| | IS | No immediate impact | | CFS: CFF | +$100 (debt proceeds) | | BS: Cash | +$100 | | BS: Debt | +$100 |

Buy back $50 of stock

| Statement | Impact | |-----------|--------| | IS | No impact | | CFS: CFF | −$50 (equity repurchase) | | BS: Cash | −$50 | | BS: Treasury Stock / Retained Earnings | −$50 |

Revenue up $100 (no associated costs, 25% tax)

| Statement | Impact | |-----------|--------| | IS: Revenue | +$100 | | IS: Net Income | +$75 | | CFS: Net Income | +$75 | | BS: Cash | +$75 | | BS: Retained Earnings | +$75 |

CapEx of $50 (buy PP&E with cash)

| Statement | Impact | |-----------|--------| | IS | No immediate impact (depreciation starts later) | | CFS: CapEx | −$50 | | BS: Cash | −$50 | | BS: PP&E | +$50 |

The universal framework

For any change, follow this sequence:

1. Income statement first — identify the P&L impact, tax-effect it
2. Cash flow statement — start with net income, add back non-cash items, adjust for working capital and investing/financing
3. Balance sheet — cash changes from CFS, retained earnings from net income, asset/liability accounts from the specific change
4. Check balance — Assets = Liabilities + Equity

Common follow-up questions

"What if the company can't use the tax shield (losing money)?" Taxes are floored at zero. If the company has no taxable income, the $10 depreciation reduces net income by the full $10 (no tax shield). Cash flow from operations: −$10 + $10 add-back = $0. No cash benefit.

"What if depreciation is $10 but PP&E also increases by $10 (replacement capex)?" Depreciation reduces PP&E by $10; capex increases PP&E by $10. Net PP&E change = $0. Cash: +$2.50 from tax shield minus $10 capex = −$7.50 net. Same balance sheet result but different cash flow path.

"Does this affect DCF valuation?" Unlevered FCF is based on EBIT, not net income — so depreciation affects DCF through EBIT (reduces it) but is added back in the UFCF calculation. The net effect on DCF is the tax shield on depreciation (same +$2.50 cash benefit).

Practice variations

Run these mentally until automatic:

1. Depreciation up $10 (tax rate 25%) → NI −$7.50, CFO +$2.50
2. Depreciation up $10 (tax rate 40%) → NI −$6.00, CFO +$4.00
3. Inventory up $10 → Cash −$10, Inventory +$10
4. Issue $100 debt → Cash +$100, Debt +$100
5. Pay $20 dividend → Cash −$20, Retained Earnings −$20
6. Revenue up $100, COGS up $60, tax 25% → NI +$30, Cash +$30

The takeaway

The depreciation walkthrough isn't about depreciation — it's about proving you understand how the three statements connect. Every IB interview tests this. Know the pattern (NI down by after-tax amount, add back depreciation on CFS, adjust cash and PP&E on BS), apply it to any variation, and always check that the balance sheet balances. Speed and confidence on this question signals that you can build and debug integrated models — exactly what banks hire analysts to do.