Recommended resources
The freely available resources this lesson will direct you to.
Hello. Last time, net income was the starting point for explaining how profit connects to cash flow and retained earnings. Today you’ll calculate that starting figure yourself. The goal is to build a simplified income statement from sales through net income, keeping operating costs, depreciation, interest, and taxes in the right places.
For an investment banking technical interview, the calculation matters, but so does the explanation: which costs belong to the business’s operations, and which arise from its financing?
Follow the income statement from top to bottom
An income statement measures performance over a period. It starts with revenue earned during that period and deducts expenses to arrive at net income. It does not simply list cash received and cash paid—a distinction that will matter again when you reconcile net income to operating cash flow.
Watch the short sections of this interview-focused introduction for the basic layout and the treatment of depreciation.
The Income Statement: The Launchpad for All Accounting Interview Questions
Watch “The Income Statement: The Launchpad for All Accounting Interview Questions” from Mergers & Inquisitions / Breaking Into Wall Street. It introduces the line items in the order you would use to construct a statement.
Watch the statement layout, from the definition through operating income and net income. Then watch depreciation for why an expense can reduce profit without being a current-period cash payment. Focus on where each item appears, rather than memorising the video’s numbers.
The first distinction is between direct costs and other operating expenses. A product seller deducts cost of goods sold (COGS)—the cost of the goods it sold—from net sales to find gross profit. It then deducts expenses such as rent, administrative salaries, and utilities to find operating income. Interest is generally below operating income because it relates to financing rather than the profitability of the company’s operations.
Read the OpenStax explanation alongside its example. It shows the full progression in an actual income-statement layout.
5.1 The Income Statement - Principles of Finance 2e | OpenStax
Read “The Income Statement” from OpenStax to see how sales, operating expenses, interest, and taxes are classified in a comparative statement.
In “Sales and Gross Profit,” begin where the text says firms report sales reductions separately. Read sales through gross profit, focusing on returns, net sales, and COGS. In “Income from Operations,” read operating expenses; note that depreciation is included among them. In “Net Income,” read the bottom-line explanation, then continue through the interest and income-tax paragraph to Figure 5.4. Stop before the “EBITDA” subsection.
The subtotals tell different stories
Here is the structure you should be able to reproduce without a template:
If revenue is already given as net revenue, start there; do not deduct returns a second time. Likewise, if a supplied operating-expense figure already includes depreciation, do not deduct depreciation again. In a fuller company statement, some depreciation may be included in COGS rather than shown as a separate operating-expense line. The rule is to count each expense once, in its stated classification.
Operating income, also called EBIT (earnings before interest and taxes), reflects profit after operating expenses, including depreciation, but before interest and taxes. Pre-tax income, also called EBT, reflects the additional cost of interest. If an interview question provides a tax rate rather than tax expense, apply the assumed rate to pre-tax income, not to revenue or EBIT. For a simplified profitable company:
If pre-tax income is negative, do not automatically assume an immediate tax refund; use the question’s tax assumptions. Similarly, a given tax expense should be used as stated rather than replaced with an invented rate.
The OpenStax example makes these distinctions visible:
In that current-year column, rent, salaries, and utilities total 13,400, while depreciation is 3,600. Thus, operating expenses total 17,000, and gross profit of 60,000 becomes operating income of 43,000. After 2,000 of interest and 6,000 of tax expense, net income is 35,000. Each subtotal answers a different question; none can be substituted for another.
Construct a statement from a short set of inputs
Suppose a company reports gross sales of 210, sales returns of 10, COGS of 80, selling and administrative expenses excluding depreciation of 50, depreciation of 10, and interest expense of 12. Assume a 25% tax rate and no other income or expenses. All amounts are in the same units.
Start by establishing net revenue of 200. COGS is a direct cost, so gross profit is 120. The 50 of selling and administrative expenses and 10 of depreciation are operating costs, leaving operating income of 60. Interest reduces pre-tax income to 48; tax expense is 12, leaving net income of 36.
| Simplified income statement | Amount |
|---|---|
| Gross sales | 210 |
| Less: sales returns | (10) |
| Net revenue | 200 |
| Less: COGS | (80) |
| Gross profit | 120 |
| Less: selling and administrative expenses, excluding depreciation | (50) |
| Less: depreciation | (10) |
| Operating income (EBIT) | 60 |
| Less: interest expense | (12) |
| Pre-tax income (EBT) | 48 |
| Less: income tax expense, | (12) |
| Net income | 36 |
This table presents expenses as positive-sized deductions in parentheses. A financial model may instead store them as negative numbers and add the rows. Either convention works; mixing the two is what causes errors.
You may also hear EBITDA—earnings before interest, taxes, depreciation, and amortisation. In this deliberately simplified example, with no amortisation and with depreciation shown separately, it is 70: gross profit of 120 less the 50 of other operating expenses. Deducting depreciation of 10 gets you to EBIT of 60. EBITDA is a useful intermediate measure, not the bottom line, and it is not the same as cash flow.
Explain what the statement does—and does not—record
Three interview distinctions prevent many otherwise sound calculations from going wrong.
First, depreciation is an expense even though it is not a cash payment made in this period. It reduces operating income and net income. As you saw last lesson, it is then added back when starting an indirect operating cash-flow reconciliation. The equipment purchase itself is not deducted in full from this period’s income statement merely because cash was spent on it.
Second, interest expense is different from debt repayment. Interest reduces pre-tax income. Repaying loan principal is not an income-statement expense; it changes cash and the debt balance.
Third, dividends are not an expense used to reach net income. They are a distribution to shareholders. In the simplified three-statement link from last lesson, dividends affect financing cash flow and retained earnings after net income has been calculated.
In a spoken answer, you can therefore proceed conclusion-first: “Net income is revenue less direct costs, other operating expenses, depreciation, interest, and taxes. I calculate gross profit first, then EBIT, then pre-tax income; I apply the assumed tax rate to pre-tax income.” That ordering makes both your arithmetic and your classifications easy to check.
Key takeaways
Build the statement in layers: net revenue, gross profit, operating income, pre-tax income, net income. Deduct depreciation in the operating section if it has not already been included in another expense figure; deduct interest below operating income; calculate taxes from pre-tax income when a rate is supplied. Net income is an accrual profit measure, not a cash balance.
Next, you’ll take the net income you can now construct and reconcile it to cash flow from operations, accounting for non-cash charges and changes in working capital.