Accounting is the foundation every other finance technical rests on. If the three statements are automatic, valuation and modelling questions become much easier. Work through these before anything else.
Try to answer each one aloud before reading the solution, the way an interviewer would ask it.
The income statement reports profitability over a period, running from revenue down through costs to net income. The balance sheet is a snapshot at a point in time where assets equal liabilities plus equity. The cash flow statement reconciles accrual net income to the actual change in cash across operating, investing and financing activities. The income statement tells you whether the business is profitable, the balance sheet tells you what it owns and owes, and the cash flow statement tells you whether the profit was real cash.
Net income from the income statement is the starting line of the cash flow statement and also flows into retained earnings within equity on the balance sheet. The cash flow statement's closing cash balance becomes the cash line on the balance sheet. Depreciation reduces income statement profit, is added back as a non-cash item in operating cash flow, and reduces net PP&E on the balance sheet. Because every entry is double sided, a change in any one statement propagates through the other two, which is exactly what the classic walkthrough questions test.
Income statement: operating income falls $10, and after a 40% tax benefit net income falls $6. Cash flow: begin with minus $6, add back $10 of non-cash depreciation, so operating cash flow and total cash rise by $4. That $4 is the depreciation tax shield, being the $10 deduction times the 40% rate. Balance sheet: cash is up $4 and net PP&E is down $10, so assets fall $6; retained earnings fall $6 with net income, so equity falls $6 and the balance sheet balances.
Accrual accounting recognises revenue when it is earned and expenses when they are incurred, regardless of when cash changes hands. Cash accounting records both only when cash moves. Accrual gives a truer picture of economic performance in a period by matching costs to the revenue they generate, which is why it is required under both GAAP and IFRS for larger entities. The cost is that profit no longer equals cash, and the gap between them is precisely why the cash flow statement exists.
FIFO assumes the oldest inventory is sold first, so in a rising price environment cost of goods sold reflects older, cheaper units, producing higher reported profit and a balance sheet inventory figure close to current cost. LIFO assumes the newest inventory is sold first, so COGS reflects current, higher costs, producing lower reported profit, lower tax and an inventory balance that can be badly outdated. LIFO is permitted under US GAAP but prohibited under IFRS, which makes cross border comparison difficult without adjustment.
EBITDA is earnings before interest, taxes, depreciation and amortisation. Build it from operating income by adding back D&A, or from net income by adding back taxes, interest and D&A. It is used as a rough proxy for operating cash flow that is comparable across different capital structures and depreciation policies. The criticism is that it ignores real costs: capex is genuinely required to sustain the business, working capital consumes cash, and interest must actually be paid. A capital intensive company can show healthy EBITDA and still generate no free cash flow at all.
Working capital is current assets less current liabilities, though for analysis the more useful measure is operating working capital: receivables plus inventory less payables, excluding cash and debt. An increase means more cash is tied up in the operating cycle, because the company is carrying more inventory, collecting more slowly, or paying suppliers faster. It is a use of cash and reduces free cash flow. A decrease releases cash. Growing companies almost always absorb working capital, which is why growth and cash generation frequently conflict.
Deferred revenue arises when a customer pays before the company delivers the good or service. Cash is received, but because the revenue has not been earned it cannot go through the income statement yet. It is recorded as a liability on the balance sheet, representing an obligation to deliver, and is recognised as revenue over time as delivery occurs. It is characteristic of subscription and software businesses, and is a genuinely favourable item because the customer is funding the business interest free.
A deferred tax liability arises when book income exceeds taxable income temporarily, so tax is deferred to future periods. The classic cause is depreciation: a company uses accelerated depreciation for tax purposes and straight line for reporting, so early on the tax deduction exceeds the book expense, cash tax paid is lower than the book tax expense, and the difference accumulates as a DTL. The gap reverses later when book depreciation exceeds tax depreciation. DTLs also arise in acquisitions when assets are written up for book purposes without a corresponding tax basis step up.
Stock-based compensation is a real expense on the income statement, recorded at the grant date fair value of the awards over the vesting period, which reduces net income. Because no cash leaves the business, it is added back as a non-cash item in operating cash flow. The offsetting credit increases equity through additional paid-in capital. It is not a free cost: it dilutes existing shareholders, which is why treating it as an add-back to reach adjusted EBITDA is widely criticised. The cost is borne in share count rather than in cash.
Under the current standards, ASC 842 and IFRS 16, essentially all leases with terms beyond one year appear on the balance sheet as a right-of-use asset and a corresponding lease liability. The classification then drives the income statement. A finance lease splits the cost into amortisation of the asset and interest expense, so it sits below EBITDA and flatters that metric. An operating lease reports a single straight line lease expense within operating costs, so it reduces EBITDA. The distinction matters for any EBITDA based comparison across lease-heavy companies.
Goodwill arises in an acquisition when the purchase price exceeds the fair value of identifiable net assets acquired. Mechanically: purchase price less the fair value of net identifiable assets, after writing assets up or down to fair value and recognising intangibles such as brands and customer relationships, leaves the residual as goodwill. It is not amortised under US GAAP. Instead it is tested for impairment at least annually, and if the acquired business underperforms, goodwill is written down, which hits the income statement as a non-cash charge and reduces both assets and equity.
Every concept above maps to a module you can practise, with the numbers regenerating on each attempt.
Reading an answer once is recognition. Interviews test recall under pressure, so the questions regenerate with fresh numbers every run.
Start practising freeThe three statement walkthrough and how a change in any one item flows through all three. Add the mechanics of depreciation, working capital, deferred revenue and deferred taxes, plus the ability to build EBITDA and explain its limitations. Interviewers care far more about the linkages than about obscure standards.
Some variant of the walkthrough: depreciation rises by $10, or inventory is written down, or a company buys equipment. The pattern never changes. Move through the income statement first, then the cash flow statement, then the balance sheet, and finish by confirming the balance sheet still balances.
Because it exists to reconcile accrual profit to cash. Starting from net income and reversing non-cash items such as depreciation and stock compensation, then adjusting for working capital changes, shows exactly why the two differ. That reconciliation is the entire point of the indirect method.