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What the interviewer is testing
Whether you can move a single change through all three statements in the right order, keep track of tax, and end with a balance sheet that balances.
Answer framework
- State the tax rate you are assuming (25% here).
- Income statement: pre-tax income falls by the change; net income falls by the after-tax amount.
- Cash flow statement: start with the lower net income, add back the non-cash depreciation; the net cash effect is the tax saving.
- Balance sheet: cash changes by the tax saving, net PP&E falls by the depreciation, retained earnings fall by the net income change.
- Check that both sides move by the same amount.
Sample answer
Assume a 25% tax rate. On the income statement, operating income and pre-tax income fall by $10, so net income falls by $7.50.
On the cash flow statement, net income is down $7.50, but depreciation is a non-cash expense, so I add back $10. Cash is up $2.50, which is the tax saving.
On the balance sheet, cash is up $2.50 and net PP&E is down $10, so total assets are down $7.50. Retained earnings fall by $7.50, so liabilities plus equity are also down $7.50. It balances.
Likely follow-ups
Common mistakes
- Saying cash goes down. Depreciation does not use cash; the only cash effect is lower taxes.
- Forgetting tax, so net income falls by the full $10.
- Forgetting to reduce net PP&E, so the balance sheet does not balance.
- Not stating the tax rate up front.
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Related questions
Based on questions #3, #2 in the full question bank.