How to Answer “What happens to the income statement, balance sheet, and cash flow statement when depreciation increases?” in Investment Banking Interviews
In investment banking interview prep, this is a classic three-statement linkage prompt: “What happens to the income statement, balance sheet, and cash flow statement when depreciation increases?” A strong analyst-level answer explains the impact of depreciation on financial statements with clear assumptions (tax rate, no change in capex, and depreciation is non-cash) and ties the maths across all three statements.
Interviewers don’t want a lecture—they want a clean walk from income statement to cash flow to balance sheet, with the sign conventions correct and a quick sanity check that everything balances.
What Interviewers Test in IB Technical Questions on Depreciation
This sits in the core set of IB technical questions because it tests whether you understand three-statement mechanics, not just individual line items. Depreciation touches operating profit, taxes, cash flow add-backs, PP&E, and retained earnings—so it’s a compact way to test linkage.
They’re also assessing communication under pressure: can you state assumptions upfront (e.g., “holding revenue and everything else constant”) and then move in a disciplined order (IS → CFS → BS) without getting lost.
Finally, it’s a mini financial statement analysis interview test: depreciation is non-cash but still affects taxes, so you need to show you understand why cash can go up while accounting earnings go down—something that matters later in modelling and valuation interview prep.
Impact of Depreciation on Financial Statements: Answer Framework
- 1
Step 1: Set assumptions and start on the income statement
Open by locking the scenario: depreciation increases by ΔD, revenue and other costs are unchanged, capex is unchanged today, and the tax rate is t. Then go straight to the income statement.
- Depreciation expense increases by ΔD (usually in COGS or operating expenses).
- EBIT decreases by ΔD.
- Pre-tax income decreases by ΔD (ignoring interest effects).
- Taxes decrease by ΔD × t.
- Therefore net income decreases by ΔD × (1 − t).
Call out the key intuition (this is the heart of “depreciation effects on income statement”): depreciation lowers accounting profit, but because it reduces taxable income, it creates a tax shield.
- 2
Step 2: Move to the cash flow statement (cash flow statement adjustments)
Go to the cash flow statement and reconcile net income to cash.
- Start with net income down by ΔD × (1 − t).
- Add back the higher depreciation (a non-cash expense) of +ΔD in CFO.
Net effect in cash flow from operations (CFO) is +ΔD × t. That’s the tax shield showing up as higher operating cash flow.
Assuming no other changes:
- Cash increases by ΔD × t.
- Cash flow from investing is unchanged (since capex is held constant in this setup).
- Cash flow from financing is unchanged.
This step is where many candidates trip: the add-back is larger than the net income decrease, so cash goes up, not down.
- 3
Step 3: Update the balance sheet (PP&E and retained earnings)
Now tie the changes onto the balance sheet so it balances.
Assets:
- Cash increases by ΔD × t (from the cash flow statement).
- PP&E (net) decreases by ΔD because higher depreciation reduces net book value.
Net change in assets = (+ΔD × t) − ΔD = −ΔD × (1 − t).
Liabilities & Equity:
- No direct liability change in the basic version.
- Retained earnings decrease by the net income impact: −ΔD × (1 − t).
So L&E changes by −ΔD × (1 − t), matching the asset change. Explicitly state the check: “Balance sheet balances.”
- 4
Step 4: Give a quick numerical example to prove the linkage
Use small numbers to demonstrate you can do this live.
Example: depreciation increases by $10, tax rate 40%.
- Income statement: EBIT −10; taxes down by 4; net income −6.
- Cash flow: net income −6; add back depreciation +10 ⇒ CFO +4; cash +4.
- Balance sheet: cash +4; PP&E −10 ⇒ assets −6; retained earnings −6 ⇒ balances.
This quick proof is often what separates a “knows it” answer from a memorised one.
- 5
Step 5: Add the one-line nuance interviewers like
Close with a controlled nuance that stays within the question.
- Higher depreciation is usually driven by higher capex in prior periods or a change in useful life/accounting policy.
- Over the long run, depreciation and capex are linked: depreciation rising today may imply you invested more earlier, which affects free cash flow and modelling.
But keep the core answer anchored: in the standard interview setup, depreciation up means net income down, operating cash flow up (tax shield), PP&E down, cash up, retained earnings down.
Analyst Model Answer: Depreciation Effects on Income Statement and Linkage
If depreciation increases—holding revenue, capex today, and everything else constant—EBIT and net income go down, but cash flow from operations goes up because depreciation is non-cash and creates a tax shield.
On the income statement, higher depreciation reduces EBIT by the increase in depreciation. Taxes fall because taxable income is lower, so net income decreases by ΔDepreciation × (1 − tax rate).
On the cash flow statement, you start with that lower net income, then add back the higher depreciation in CFO. The add-back is larger than the net income drop, so CFO increases by ΔDepreciation × tax rate. With no other changes, ending cash increases by that same amount.
On the balance sheet, cash increases by the change in ending cash, and PP&E (net) decreases by the increase in accumulated depreciation, i.e., by ΔDepreciation. The net change in assets is negative by ΔDepreciation × (1 − tax rate), which is matched by a decrease in retained earnings equal to the net income decline. So the balance sheet still balances.
As a quick check: if depreciation is up $10 at a 40% tax rate, net income is down $6, CFO is up $4, cash is up $4, PP&E is down $10, and retained earnings are down $6.
- State assumptions early (tax rate, no other changes) to keep the linkage clean.
- Use the formula pattern: NI −ΔD(1−t); CFO +ΔD·t; PP&E −ΔD; Cash +ΔD·t; RE −ΔD(1−t).
- Say “non-cash expense + tax shield” out loud—this is the why behind the signs.
- A 10-second numeric example reduces sign mistakes and builds credibility.
Common Three-Statement Linkage Mistakes Candidates Make
- Saying cash decreases because net income decreases, ignoring the depreciation add-back in CFO.
- Forgetting the tax shield and claiming net income falls by the full depreciation amount.
- Moving PP&E in the wrong direction (higher depreciation reduces net PP&E).
- Not tying the balance sheet (cash, PP&E, and retained earnings) back to the exact same numbers.
- Mixing in capex changes in the base case; the prompt is about a depreciation increase, not a new capex decision today.
- Overcomplicating with deferred taxes or policy changes without being asked; add nuance only after the core linkage is correct.
Follow-Ups: Cash Flow Statement Adjustments and Valuation Angles
How does increased depreciation affect free cash flow and valuation?
Unlevered FCF typically increases by ΔD × tax rate (higher tax shield) if capex is unchanged, which can raise DCF value all else equal—though in reality higher depreciation often reflects past capex.
What if the company is not paying cash taxes (e.g., due to NOLs)?
If cash taxes are effectively zero, the tax shield may not create near-term cash savings, so CFO may be closer to flat: net income down, add-back up, but taxes don’t fall in cash terms.
Where does depreciation show up on the cash flow statement?
In most formats it’s added back in cash flow from operations as a non-cash expense adjustment after net income.
How is this different from capex increasing?
Higher capex reduces cash in investing cash flow immediately and increases PP&E; depreciation affects the statements gradually through expense and the add-back, with a tax shield effect.
What happens to EBITDA when depreciation increases?
EBITDA is unchanged because depreciation is added back to get from EBIT to EBITDA.
How to Practise This Financial Statement Analysis Interview Question
- Drill a 60–90 second delivery: IS (NI impact) → CFS (add-back) → BS (cash, PP&E, retained earnings) → “it balances.”
- Memorise the compact formulas using ΔD and t, then confirm with a $10 example to avoid sign errors.
- Practise variants common in impact of depreciation on financial statements in investment banking: different tax rates, zero-tax/NOL scenario, and “what if capex changes too?”
- On AceTheRound, rehearse this as a timed prompt and review whether you stated assumptions and balanced the balance sheet before adding nuance.
Ready to practice with AceTheRound?
Create an account to unlock AI mock interviews, feedback, and the full prep library.