“Walk me through the three financial statements.”
This is probably the very first technical question you will get in an Investment Banking interview. You will 100% get this question. Your answer should be short and concise. Nothing more than 2-3 minutes.
Mediocre answer: You are hesitating and unsure whether what you say is correct. You are almost asking the interviewer to tell if you are right or not. On the other hand, don’t go into super detail and start discussing detailed accounts. This is a high-level question. You should be able to highlight what’s important vs. what’s too detailed and not necessary.
Good answer: You structure your answer. Then you provide high-level commentary according to your structure. All delivered with a calm demeanor. You properly shed light on the three statements and their purpose. Then you move on to the next question.
How to answer “Walk me through the three financial statements”
The core financial statements are the income statement, cash flow statement and balance sheet.
The income statement is a measure of profitability – revenues less expenses are taxed and create net income. It measures the company’s profitability over a defined period. The income statement recognizes revenues and expenses based on when they are incurred. This is a good way to measure profitability over a time period. However, this does not reflect actual cash flow.
The cash flow statement tracks how much cash has been spent or generated from three major areas: operating, investing and financing. It tracks the company’s cash flow over the fiscal year. The cash flow statement is needed because the income statement only accounts for incurred revenues and expenses. On the other hand, the cash flow statement adjusts the net income from the income statement with working capital, Capex and debt/equity raises. This reflects the actual cash flow of a company within the time period.
The balance sheet is a snapshot of a company’s resources (assets), obligations (liabilities) and equity. The assets must always equal the sum of a company’s equity and liabilities. In other words, the balance sheet captures how the company uses its resources (assets) and where they come from (debt or equity). Unlike the two statements above, the balance sheet is a snapshot in time on a specific date.
How do the three financial statements link together?
There are three main connections that you need to be aware of:
(1) Net income to cash flow statement – Net income flows from the bottom of the income statement to the top of the cash flow statement, which adjusts net income for all cash and non-cash changes to obtain the net changes in cash for the period.
(2) Net changes in cash to cash on balance sheet – Net changes in cash for the period are netted with the beginning cash balance to derive the ending cash balance. This balance flows into cash and equivalents on the balance sheet.
(3) Net income to retained earnings – Net income from the P&L less dividends flows into retained earnings of the balance sheet. Now the balance sheet balances.
Additional resources
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