How to Answer “How do the three financial statements link together?” in Investment Banking Interviews
In investment banking interview prep, few financial statements interview questions come up as often as: “How do the three financial statements link together?” Interviewers want a clear, mechanics-first explanation that shows you understand how performance flows through to cash and the balance sheet.
At an analyst level, the goal is to explain the links in the right order (Income Statement → Cash Flow Statement → Balance Sheet), name the key line items that bridge them, and sanity-check that the model balances.
What Interviewers Evaluate in Financial Statements Interview Questions
Interviewers use this prompt to test whether you understand the core accounting mechanics that underpin financial modeling interview prep: how net income becomes cash, why the balance sheet must balance, and how non-cash items and working capital reconcile profit vs cash.
They’re also evaluating whether you can communicate like you would on the job in investment banking—structured, prioritised, and precise. A good answer sounds like a mini walkthrough you could give while building or checking a three-statement model.
Finally, they’re checking judgement and error-detection. The best candidates mention at least one or two sanity checks (cash and balance sheet balancing; sign conventions on working capital; treatment of depreciation and capex) that prevent common modelling breaks before they show up in a valuation output.
Answer Framework for Linking the 3 Statements (IB Technical Questions)
- 1
Step 1: Start with the flow—Income Statement to Cash Flow Statement
Open by stating the direction of flow: operating performance drives profitability (Income Statement), which reconciles to cash generation (Cash Flow Statement). The key bridge is net income.
From net income, you adjust for:
- Non-cash expenses (e.g., depreciation & amortisation, stock-based comp) added back because they reduce accounting profit but not cash.
- Changes in net working capital (e.g., AR, inventory, AP) to convert accrual earnings into cash earnings (increase in operating assets is a cash outflow; increase in operating liabilities is a cash inflow).
This produces cash flow from operations (CFO)—the first major link that explains why a business can be profitable but cash-negative (or vice versa). Mentioning the cash flow statement explicitly here is important because it’s where most interview explanations either get vague or skip the reconciliation.
- 2
Step 2: Connect investing and financing to changes in cash
Next, explain that the Cash Flow Statement aggregates three sections—CFO, cash flow from investing (CFI), and cash flow from financing (CFF)—which together explain the period’s net change in cash.
- In CFI, the headline item is usually capex, which reduces cash and increases PP&E on the balance sheet (net of depreciation). You may also mention acquisitions/divestments and investments in other companies.
- In CFF, items like debt issuance/repayment, equity issuance/repurchase, and dividends change cash and simultaneously change the corresponding balance sheet accounts (debt, share capital/treasury stock, retained earnings via dividends).
Conclude the step with the identity: Beginning cash + net change in cash = Ending cash. That ending cash is the cash line on the Balance Sheet, making cash the cleanest ‘plug’ that ties the statements together mechanically.
- 3
Step 3: Tie the Balance Sheet back—retained earnings and supporting schedules
Now link the Balance Sheet back to the Income Statement. The most direct connection is retained earnings: net income increases equity, and dividends (if any) reduce it.
A compact way to say it:
- Net income from the Income Statement flows into retained earnings on the Balance Sheet.
- The Balance Sheet also reflects other Income Statement and cash flow impacts through ‘supporting’ accounts:
- PP&E changes by capex (from CFI) minus depreciation (from the Income Statement/non-cash add-back).
- Working capital accounts (AR, inventory, AP) change on the Balance Sheet and those changes are what you used in CFO.
- Debt and share count/equity move based on financing activities.
This step shows you understand the model is not three separate documents—it’s one integrated system with schedules (working capital, PP&E, debt) that make the links explicit.
- 4
Step 4: Prove it balances—sanity checks an IB analyst would run
Finish with how you would confirm the linkage is correct—this is where strong candidates separate themselves in ib technical questions.
Key checks:
- Balance Sheet balances: Assets = Liabilities + Equity every period.
- Cash matches: Ending cash on the Cash Flow Statement equals cash on the Balance Sheet.
- Retained earnings roll-forward: Beginning RE + net income − dividends (± other equity items) = ending RE.
- Sign conventions: An increase in AR/inventory is a cash outflow; an increase in AP is a cash inflow.
Optionally note why it matters: these links underpin forecasting accuracy and, downstream, outputs used in a valuation techniques interview (e.g., enterprise value bridge, leverage, and free cash flow).
Analyst Model Answer: Three-Statement Link Explained
The three financial statements link because the Income Statement explains profitability, the Cash Flow Statement reconciles that profit to cash, and the Balance Sheet captures the cumulative result at a point in time.
Practically, I start with net income on the Income Statement. On the cash flow statement, net income is adjusted for non-cash items like depreciation and for changes in working capital to arrive at cash flow from operations. Then I add investing cash flows like capex and financing cash flows like debt issuance/repayment and dividends to get the net change in cash.
That net change rolls into the Balance Sheet: ending cash on the Cash Flow Statement becomes the cash line on the Balance Sheet. At the same time, Income Statement items flow into equity—net income increases retained earnings, and dividends reduce it. Other Balance Sheet lines move based on the same drivers: working capital accounts change in line with the working capital adjustment in CFO, PP&E increases with capex and decreases with depreciation, and debt changes with financing flows.
As a check, the Balance Sheet should balance every period, ending cash should match between the cash flow statement and the Balance Sheet, and retained earnings should roll forward cleanly from beginning to ending based on net income and distributions.
- State the direction of flow early (IS → CFS → BS) to stay structured under time pressure.
- Name the specific bridges (net income, non-cash items, working capital, capex, debt/dividends) rather than speaking in generalities.
- Include at least two sanity checks (balance sheet balances; cash matches; retained earnings roll-forward).
- Keep it model-oriented: describe what moves, where it shows up, and why the numbers reconcile.
Mistakes That Break Three-Statement Models in Financial Modeling Interview Prep
- Explaining the statements in isolation instead of describing the mechanical links (net income to CFO, ending cash to Balance Sheet, retained earnings to equity).
- Getting working capital signs wrong (e.g., saying higher AR increases cash) or avoiding working capital altogether.
- Ignoring non-cash items like depreciation, which is a common reason profit and cash diverge.
- Forgetting that financing activities affect both cash and the related Balance Sheet accounts (debt/equity), not just ‘cash changes’.
- Not mentioning any checks to prove the linkage works (cash matching, Balance Sheet balancing, retained earnings roll-forward).
- Overloading the answer with niche line items instead of the core drivers an analyst uses in a three-statement model.
Likely Follow-Ups in Investment Banking and Valuation Techniques Interviews
If depreciation increases by $10, what happens across the three statements?
Operating income and net income fall by $10 on the Income Statement; on the cash flow statement you add back $10 so cash is higher by $10 vs net income; PP&E on the Balance Sheet is $10 lower (all else equal), and retained earnings are lower from the reduced net income.
Walk me through a $10 increase in accounts receivable.
Revenue is unchanged, but on the cash flow statement the working capital change is a $10 use of cash, so cash falls by $10; on the Balance Sheet, AR is up $10 and cash is down $10 (no immediate impact to net income).
How does capex flow through the statements?
Capex is not on the Income Statement immediately; it’s an investing cash outflow on the cash flow statement and increases PP&E on the Balance Sheet, then affects the Income Statement over time via higher depreciation.
How do dividends link the statements?
Dividends are a financing cash outflow on the cash flow statement, reduce cash on the Balance Sheet, and reduce retained earnings within equity (they don’t run through the Income Statement).
Why does this matter for valuation work?
Because free cash flow and leverage metrics depend on correctly reconciling profit to cash and tracking Balance Sheet items; weak linkages can distort outputs used in valuation techniques interview questions.
How to Practise This Explanation with AceTheRound
- Practise a 60–90 second version that hits the three bridges: net income → CFO, net change in cash → cash on Balance Sheet, net income → retained earnings.
- Drill two micro-walkthroughs out loud (depreciation change; working capital change). These are common follow-ups in IB technical questions.
- When you rehearse, always end with checks: “cash matches” and “the Balance Sheet balances.”
- In AceTheRound, run this as a timed response and listen back for missing links (working capital, capex/PP&E, retained earnings).
Ready to practice with AceTheRound?
Create an account to unlock AI mock interviews, feedback, and the full prep library.