How do the 3-Statements link together in IB interviews?

Key Line Items

Interview Approach

Work at the Pre-Tax Income line. Ask: "By how much does this item change Pre-Tax Income?" Then apply taxes:

Do not walk line by line through Revenue → Gross Profit → Operating Income unless specifically asked. State the pre-tax impact, then the after-tax impact.

Example: COGS increases by $100:

• Pre-Tax Income decreases by $100
• Net Income decreases by $\text{\$}100\times (1-\text{tax rate})$

Revenue Recognition Principle

Revenue appears on the Income Statement when value is delivered, regardless of cash timing.

Example: Sell $1,000 of product on credit in Q1; customer pays in Q2.

Q1:

• Income Statement: Revenue +$1,000
• Cash Flow Statement: Working Capital outflow of $1,000 (AR increase), CFO −$1,000
• Balance Sheet: Accounts Receivable +$1,000, Cash −$1,000

Q2:

• Income Statement: No impact (value already recognized)
• Cash Flow Statement: Working Capital inflow of $1,000 (AR collected), CFO +$1,000
• Balance Sheet: Cash +$1,000, Accounts Receivable −$1,000

Common Trap: Deferred Revenue

Question: "A customer pays for a one-year subscription upfront. Walk me through the statements."

Trap: Recognizing all revenue immediately because cash came in.

Correct Answer:

• Cash Flow Statement: CFO increases (cash received)
• Balance Sheet: Cash increases; Deferred Revenue (liability) increases by same amount
• Income Statement: No impact at receipt—revenue recognized ratably over the year
• Each period: IS shows 1/12 of revenue; Deferred Revenue decreases by 1/12

Classification Logic

• If cash actually changed hands → appears directly in the appropriate CFS section
• If it shows on the Income Statement but cash didn't move → adjust for it in CFO

Cash from Operations (CFO)

Start with Net Income, then make two adjustment types:

Non-cash charges (add back):

• Depreciation & Amortization
• Stock-based compensation
• Deferred taxes
• Impairment charges

Working Capital changes:

• AR increase → cash outflow (sales made, not collected)
• Inventory increase → cash outflow (paid for inventory)
• AP increase → cash inflow (received goods, haven't paid)

Cash from Investing (CFI)

Typically negative—companies invest in their future:

• Capital Expenditures (CapEx) for PP&E
• Purchases/sales of long-term investments
• Acquisitions/divestitures

Cash from Financing (CFF)

Capital structure changes:

• Debt issuance/repayment
• Equity issuance
• Dividends
• Share buybacks

Interview Shortcut: IS Impact Test

1. Does it impact the Income Statement?

   • YES → Flows through CFO (starting from Net Income), with adjustments if cash timing differs
   • NO → Goes directly into CFI or CFF

2. "NO" examples: Taking out a loan, issuing stock, buying PP&E, paying dividends

3. "YES" examples: Revenue, COGS, operating expenses, depreciation (added back in CFO)

Net Change Calculation

This reconciles beginning-of-period Cash to end-of-period Cash on the Balance Sheet.

Organization: Liquidity Ordering

Each section ordered from most liquid/current to least.

Current Assets:

• Cash
• Accounts Receivable
• Inventory
• Prepaid Expenses

Non-Current Assets:

• Property, Plant & Equipment (PP&E)
• Intangible Assets
• Goodwill
• Long-term Investments

Current Liabilities:

• Accounts Payable
• Accrued Expenses
• Short-term Debt
• Deferred Revenue

Non-Current Liabilities:

• Long-term Debt
• Deferred Tax Liabilities
• Pension obligations

Shareholders' Equity:

• Common Stock: Par value of shares issued
• Additional Paid-in Capital (APIC): Amount raised above par
• Retained Earnings: Cumulative profits kept in business
• Treasury Stock: Cost of shares bought back (negative equity)

Retained Earnings Bridge

This connects the Income Statement to the Balance Sheet:

Every dollar of undistributed profit flows here.

Inventory Purchase

"The company spends $1,000 on inventory. Walk me through the three statements."

Assume cash purchase.

Step 1: Classification

Buying inventory is a cash transaction that doesn't immediately impact the IS (not sold yet). Start with CFS.

Step 2: Cash Flow Statement

• CFO: Inventory increase → Working Capital outflow → CFO −$1,000
• Net Change in Cash: −$1,000

Step 3: Balance Sheet (Immediate)

• Assets: Cash −$1,000, Inventory +$1,000
• Total Assets: Unchanged (mix shift from cash to inventory)
• Liabilities and Equity: No change

Step 4: Income Statement

No impact—expense hits when sold as COGS.

Subsequent Sale

Sell inventory for $1,500 cash. Tax rate: 40%.

Income Statement:

• Revenue: +$1,500
• COGS: −$1,000
• Pre-Tax Income: +$500
• Taxes: −$200
• Net Income: +$300

Cash Flow Statement:

• CFO: Net Income +$300, Inventory decrease +$1,000 → CFO: +$1,300
• CFI: $0
• CFF: $0
• Net Change in Cash: +$1,300

Balance Sheet:

• Assets: Cash +$1,300, Inventory −$1,000 → Net Assets: +$300
• Liabilities: No change
• Equity: Retained Earnings +$300

Total Assets +$300 = Total Liabilities $0 + Total Equity +$300

Lock this concept down. Nothing more advanced matters without this foundation.

For tax timing differences, see Deferred Tax Assets & Liabilities.