When interviewing for investment banking, private equity, or related finance positions, understanding how depreciation flows through the three financial statements is crucial. This guide will walk through the mechanics, common interview questions, and key considerations for handling depreciation in financial modeling.
Contents
Core Concept: What is Depreciation?
Depreciation is a non-cash expense that allocates the cost of a tangible asset over its useful life. This accounting concept affects all three financial statements in different ways, making it a perfect topic for testing a candidate’s understanding of financial statement interconnectedness.
Impact on Each Financial Statement
Income Statement Impact
Depreciation appears as an operating expense, typically under SG&A or as its own line item. This reduces operating income (EBIT) and net income, but because it’s a non-cash expense, we need to add it back in the cash flow statement.
Balance Sheet Impact
Depreciation affects two areas of the balance sheet:
- Accumulated depreciation increases, which is a contra-asset account
- The net PP&E value decreases by the same amount
- Retained earnings decreases through net income reduction
Cash Flow Statement Impact
In the cash flow statement, depreciation appears as an add-back to net income in the operating cash flow section, since it’s a non-cash expense that reduced net income but didn’t actually consume cash.
Step-by-Step Model Building Process
Step 1: Set Up PP&E Schedule
First, create a detailed PP&E schedule that tracks:
- Beginning PP&E balance
- Capital expenditures (additions)
- Disposals
- Depreciation expense
- Ending PP&E balance
Step 2: Calculate Depreciation
There are several methods to calculate depreciation:
- Straight-line method (most common in models)
- Declining balance
- Sum-of-years-digits
For interview purposes, focus on straight-line depreciation:
Annual Depreciation = (Original Cost – Salvage Value) / Useful Life
Step 3: Link to Financial Statements
Income Statement Links
- Add depreciation expense as a line item
- This flows into EBIT calculation
- Impacts EBT and net income
Balance Sheet Links
- Update accumulated depreciation
- Calculate net PP&E
- Update retained earnings through net income
Cash Flow Statement Links
- Add depreciation back to net income
- Include capex in investing cash flows
- Net effect shows true cash impact of fixed asset investments
Common Interview Questions and Sample Answers
Question 1: “If depreciation increases by $10 million, how does this flow through the three statements?”
Answer: Let’s trace this change through each statement:
Income Statement:
- Depreciation expense increases by $10M
- EBIT decreases by $10M
- Net income decreases by $10M × (1 – tax rate)
Balance Sheet:
- Accumulated depreciation increases by $10M
- Net PP&E decreases by $10M
- Retained earnings decreases by $10M × (1 – tax rate)
Cash Flow Statement:
- Lower net income by $10M × (1 – tax rate)
- Add back higher depreciation of $10M
- Net operating cash flow increases by $10M × tax rate
Question 2: “Is depreciation a source or use of cash?”
Answer: Depreciation itself is neither a source nor use of cash – it’s a non-cash expense. However, in the cash flow statement, it appears as an add-back to net income because:
- It reduced net income but didn’t use cash
- We need to reverse this reduction to get to actual cash flow
- The real cash impact comes from the original capital expenditure
Question 3: “How does accelerated depreciation affect the three statements differently than straight-line?”
Answer: The key differences are:
- Income Statement: Higher expenses in early years, lower in later years
- Balance Sheet: Faster reduction in net PP&E value initially
- Cash Flow Statement: Larger add-backs early, smaller later
- Tax implications: Earlier tax savings due to higher early expenses
Advanced Modeling Considerations
Working Capital Impact
Remember that depreciation doesn’t affect working capital because:
- It’s a non-cash expense
- Affects long-term assets rather than current assets or liabilities
- No impact on operating working capital calculations
Tax Implications
Consider how depreciation affects taxes:
- Reduces taxable income
- Creates tax shield
- Different depreciation methods for tax vs. books
- Impact on deferred taxes
Forecasting Considerations
When modeling future periods:
- Link depreciation to historical and projected capex
- Consider asset useful life assumptions
- Account for different depreciation schedules
- Factor in disposal/sale of assets
Model Quality Control
To ensure your model handles depreciation correctly:
Integrity Checks
- Depreciation add-back equals income statement expense
- Net PP&E changes tie to PP&E schedule
- Balance sheet changes flow correctly to cash flow statement
Common Mistakes to Avoid
- Double-counting depreciation
- Forgetting to link PP&E schedule to statements
- Mixing tax and book depreciation
- Incorrect treatment of asset disposals
Best Practices for Interviews
When discussing depreciation in interviews:
- Start with the basic mechanics
- Demonstrate understanding of three-statement linkages
- Show awareness of tax implications
- Highlight practical considerations in modeling
- Discuss any relevant industry-specific factors
How to Structure Your Answer
- Begin with definition and purpose
- Walk through statement impacts systematically
- Highlight key considerations and complexities
- Demonstrate business implications understanding
Conclusion
Understanding how depreciation flows through the three statements is fundamental to financial modeling and analysis. In interviews, focus on:
- Clear articulation of mechanical relationships
- Demonstration of practical modeling knowledge
- Understanding of business and tax implications
- Awareness of common pitfalls and best practices
Remember that interviewers are testing both technical knowledge and ability to communicate complex financial concepts clearly and confidently.
