Walk me through how a $10 increase in depreciation expense flows through the three financial statements, assuming a 30% tax rate.
A core FP&A interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
Income statement: depreciation rises $10, cutting pre-tax income by $10; at a 30% tax rate the tax charge falls $3, so net income decreases by $7. Cash flow statement: start from net income down $7, then add back the $10 of depreciation (a non-cash expense), giving a net increase of $3 in cash from operations (the $3 is the tax saving the extra depreciation generated). Balance sheet: PP&E falls $10 (accumulated depreciation), cash rises $3, so total assets fall $7; on the other side retained earnings fall $7 (the lower net income). Both sides drop by $7, so the balance sheet balances. The key insight is that the non-cash depreciation actually increases cash by the value of its tax shield ($10 × 30% = $3).
WHAT INTERVIEWERS LISTEN FOR
- ✓IS: pre-tax −$10, tax −$3, net income −$7
- ✓CF: −$7 net income + $10 add-back = +$3 operating cash (the tax shield)
- ✓BS: PP&E −$10, cash +$3 → assets −$7; retained earnings −$7
- ✓Balances; depreciation raises cash via its tax shield
COMMON MISTAKES
- ✗Assuming net income falls by the full $10 (ignoring the tax shield)
- ✗Forgetting to add back depreciation on the cash flow statement
- ✗Balance sheet not balancing
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