Accounting Foundations

Why interviewers start here

Almost every technical interview opens with "walk me through the three statements". The interviewer is not testing memory of line items — they want to hear that you understand how the statements link, because every model you will build (DCF, LBO, merger) is a three-statement model underneath.

The three statements in one breath

• Income statement — revenue and expenses over a period, on an accrual basis, ending at net income.
• Balance sheet — assets = liabilities + shareholders' equity at a point in time.
• Cash flow statement — starts at net income, adjusts for non-cash items and changes in working capital, then adds investing and financing cash flows to reach the net change in cash.

A strong 30-second answer: "The income statement shows profitability. Net income flows to the top of the cash flow statement, which adds back non-cash charges like D&A, adjusts for working capital, and adds investing and financing activity to get the change in cash. That change updates cash on the balance sheet, and net income less dividends flows into retained earnings, so the balance sheet balances."

Accrual versus cash

Accrual accounting records revenue when it is earned and expenses when they are incurred, not when cash moves. That is why the cash flow statement exists: it reconciles accrual profit to actual cash. Credit sales raise revenue and accounts receivable without any cash; D&A spreads a past capex payment over the asset's life.

Worked example: depreciation up by $10 (25% tax)

Assets fall by 7.5 and equity falls by 7.5, so the balance sheet balances. The +2.5 of cash is the tax shield: depreciation is non-cash, but it lowers the tax bill.

Worked example: inventory up by $10, paid in cash

• Income statement: no change — inventory is expensed through COGS only when it is sold.
• Cash flow statement: the increase in inventory is a use of cash, so cash from operations falls by 10.
• Balance sheet: cash −10, inventory +10. Total assets are unchanged.

Common traps

1. Forgetting taxes when an expense changes (the answer is never "net income −10" for a pre-tax item).
2. Saying depreciation "creates cash". It reduces taxes; the add-back only reverses a non-cash expense.
3. Putting dividends on the income statement — they reduce retained earnings and appear in financing cash flow.
4. Mixing up the direction of working capital: an increase in an operating asset uses cash.

How to practise

Say the linkage out loud, then run two or three single-line changes (D&A, inventory, accrued compensation, a debt-funded asset purchase) through all three statements and finish every answer with "and the balance sheet balances because…". Open the diagram checkpoints next to see the full set of linkages.

What working capital measures

Working capital is current assets minus current liabilities. In valuation and modelling we usually care about operating working capital, which excludes cash and debt:

Operating NWC = accounts receivable + inventory + prepaid expenses − accounts payable − accrued expenses − deferred revenue

It measures how much cash is tied up in running the business day to day.

The cash conversion cycle

Cash buys inventory, inventory is sold on credit, receivables are collected, and suppliers are paid on their own terms. Three day-count ratios describe the loop:

Cash conversion cycle = DIO + DSO − DPO.

Worked example

Revenue 730, COGS 438, accounts receivable 80, inventory 60, accounts payable 36.

• DSO = 80 ÷ 730 × 365 = 40 days
• DIO = 60 ÷ 438 × 365 = 50 days
• DPO = 36 ÷ 438 × 365 = 30 days
• Cash conversion cycle = 50 + 40 − 30 = 60 days

If the company negotiated 45-day supplier terms, payables would rise to 54 (438 × 45 ÷ 365) and the cycle would shrink to 45 days, releasing 18 of cash.

How changes hit the cash flow statement

The rule to memorise: an increase in an operating asset uses cash; an increase in an operating liability frees cash.

• Accounts receivable up 20 → cash from operations −20 (revenue was booked but not collected).
• Accrued compensation up 10 → the expense hits net income (−7.5 after 25% tax), but the accrual is added back (+10), so cash rises 2.5.
• Deferred revenue up 15 → cash collected before revenue is earned, so cash from operations +15.

Is negative working capital bad?

Not necessarily. Retailers, restaurants and subscription software companies often have negative working capital because customers pay up front (cash or deferred revenue) while suppliers are paid later. That is a sign of bargaining power and funds growth. It is a warning sign only when it comes from stretching payables because the company cannot pay its bills.

Interview angles

1. "Why does an increase in accounts receivable reduce cash flow?" Revenue was recognised on an accrual basis but the customer has not paid yet.
2. "What is the difference between accounts receivable and deferred revenue?" AR is revenue earned but not collected (an asset); deferred revenue is cash collected but not yet earned (a liability).
3. In a DCF, the change in NWC, not the level, enters unlevered free cash flow. Growing companies usually invest in working capital every year.

Use the working capital cycle diagram in this module to trace each arrow before you answer.