Introduction to Financial Modeling Interview Questions
If you are planning to attend a financial analyst interview or planning to make a career in financial modeling or corporate finance, this guide helps you in finding the best interview questions that are common for financial modeling interviews, with their answers. This guide is helpful in hiring the financial modeling analyst, Financial Analyst, Financial Planner, Financial Consultant, Finance Research Manager, etc.
Top 20 Financial Modeling Interview Questions with Answers
Financial Modeling Interview questions with answers are as per below:
1. What is Financial Modeling and the Use of Financial Modeling?
This would be the first and important question during a financial analyst or other related interviews.
Financial modeling is a mathematical representation of a future financial statement in the form of a spreadsheet, which explains the plans for future revenue and expenses. This is a textbook explanation of financial modeling, but the interviewer wants you to explain financial modeling in your understanding.
Whenever we need to make any financial decisions of any company, we have to check future projections in the form of financial statements, and on the basis of these financial statements we need to decide if that would be a wise decision. So, preparing those financial projections sheets, we need to learn financial modeling tools. The three main financial statements that need to be prepared would be the Income statement, Balance Sheet, and Cash Flow.
2. What are the Steps for Preparing Financial Modeling?
Financial modeling is a vast subject to explain as different projects or investment needs a different kind of strategy to follow and build the best financial model. It depends on person to person or project to project as the requirement or result from any financial model is different. But there are some steps to follow to build a financial model which are as follows.
- Collect information for the project.
- Prepare an assumption sheet for all information.
- Design a template that is easily understandable by all stakeholders.
- Interlink all related financial statements.
- Test all links and formulas.
- Prepare results summary and documents.
3. What are the Various Techniques of Company Valuation? Explain Briefly
This would be an important question during your financial modeling interview session as this is an important role of any financial analyst in his career.
There are three types of techniques or method of determining of valuation of any company which is as follows:
- DCF (Discounted Cash flow) Method: DCF (Discounted Cash Flow) is one of the methods to calculate the firm’s value by determining the present value of future cash flow.
- Market Value Business Valuation Method: This method of valuation determines a firm, asset, or any other kind of security value by the selling value of similar items in the market.
- Asset Approach: In this type of valuation method, the firm’s net value would be determined by the net value of present assets in the company.
4. What is the Difference between Debt Financing and Equity Financing? Which is more Expensive?
At the time of raising funds, companies do have two option of raising funds, Debt Financing or Equity Financing. Both options have their own advantages and disadvantages.
Debt Financing: In this form, companies raise funds in the form of a loan which comes with an interest portion with it. The company would have a monthly obligation to repay it. The main advantage of debt financing is that in this form there is no control of the lender in the business and at the time of full repayment, the relationship between company and lender ends. But the main disadvantages of debt financing are there would be a limit of raising funds that are equal to security collateralized with the financier.
Equity Financing: In this form, the company may raise more amount of funding as compared to debt financing. The financier would acquire some of the ownership of the company and provide funds as per the working capital requirement. There is no monthly obligation of repayment of funds and no interest portion would be added to the principal amount. But that doesn’t mean that there are no disadvantages with Equity funding. As the financier would have full control in the company, so the company has to share the profit margin with investors and for any decision making for the company, we have to consult with the investors.
As per the differences between these two, equity financing is more expensive than debt financing. Debt financing would have only interest portion in repayment, but in the form of equity financing, the company would have to share profits and at the time of exit, the investor will be first parties to take back the money at the ownership percentage they hold in the company.
5. What is DCF?
DCF (Discounted Cash Flow) is the best valuation method to calculate the value of the firm at the time of acquisition or financing. In DCF, the net present value would be calculated for future cash flows. For DCF, financial analyst, first prepare forecasted financial statements such as Balance Sheet, Income Statement and Cashflow. To calculate the valuation of a firm on the basis of DCF, we will use the below formula,
DCF = CF1/ (1+r)1 + CF2/ (1+r)2 + CF3/ (1+r)3 …..+ CFn/ (1+r)n
- CF1, CF2, CF3 or CFn = Cash flow for future periods.
- r= the discount rate.
- n=no. of years.
6. What are the Different kinds of Financial Statements? Explain Briefly
There are 3 kinds of financial statements which have to be prepared by any firm for any financial year, which are as follows.
1. Balance Sheet: A Balance sheet is the summary of the financial situation of a business which shows the actual position of assets, liabilities, cash, or bank balance at a particular period of time. It also shows the total no. of debt and actual equity position of the company.
2. Income Statement: An income statement that also refers to a Profit and loss account is one of the main kinds of financial statements of the company which shows the revenue, expenses, and net profit (or loss) of the company at a particular period of time.
3. Cash Flow: Cash flow is another kind of financial statement which shows the flow of cash in the company for a particular period of time.
7. Explain Different kinds of Financial Ratios?
Financial ratios are a key indicator of the financial health of any company. These ratios are the relationship between two numerical values derived from the financial statement to understand the financial health of the company. There are 5 kinds of financial ratios explained as follows:
- Liquidity ratios
- Profitability Ratios
- Efficiency Ratios
- Leverage Ratios
- Market Valuation Ratios
8. What do you Understand from Working Capital?
Working capital refers to the money available with any business for day to day operations. Working capital could be calculated from the below formula.
Working capital = Current Assets – Current Liabilities
9. What is NPV and IRR? Explain How do you Calculate them?
NPV and IRR are different kinds of methods to calculate the internal rate of returns which are useful for analyzing and comparing two or more projects for investment purposes. These concepts are very important in financial modeling. Below are the basic details and formulas to calculate each method.
NPV (Net Present Value): NPV (Net Present Value) as the name suggests, is used to calculate the present value of all cash flows generated from a project, cash flows could be negative or positive. It is basically the difference between the present value of cash inflow and cash outflow for any project.
NPV = [ Cash Inflow/ (1+r) t] – Cash Outflow
- r= Discount Rate
- t= no. of periods
IRR (Internal Rate of Return): IRR is one of the best methods and widely used in investing projects. IRR is the rate of return at which the NPV of all cash inflow or cash outflow of any project become zero (0).
Each firm has its own pre-decided required rate of return from any project. If IRR is higher than the required rate of return, that project should be accepted otherwise it should be rejected.
We can calculate IRR from the below formula,
IRR = 0 = CF0 + CF1/ (1+IRR) +CF2/ (1+IRR)2 +… CFn / (1+IRR)n
- CF0 = Cash outflow or Initial investment
- CF1, CF2 and CFn = Cash inflow
- n = time period
10. What are the Different Sections in the Profit and Loss Account?
Profit & loss account is a financial statement that shows the total no. of sales, expenses (fixed or variables), and net profit (loss) in the company for a particular period of time. There are 3 main sections in a profit & loss account, which are as below.
- Income or Revenue section: In this section, total revenue (income from main business activities and other incomes) would be included and gross profit will be calculated.
- Overhead section: In this section, all kinds of overheads or expenses would be included.
- Profit or Loss section: At this level in the profit & loss account, the net profit (or loss) would be calculated.
11. Suppose there is Excess Cash in our Balance Sheet, what would you Suggest for using it in Proper Ways?
Many times, the interviewer asks these kinds of questions, they want to check your practical awareness as well.
If there is excess cash in the balance sheet, first we should check other line items in the balance sheet, according to other balances, we should suggest using cash in proper ways, some of the ways could be as below.
- We can use excess cash for investing in modern machinery or equipment, which could be further useful in increasing revenue for the company.
- We could save on interest charges by paying long term liabilities in case we have excess cash in the balance sheet.
- We can use some part of excess cash for rewarding its shareholders in the form of dividends.
- Other uses of excess cash could be investing in other new business ventures or investing in other listed stocks.
12. What do you Understand from WACC? How would you Calculate it?
WACC (Weighted Average Cost of Capital) is an average rate of return which the company is expected to pay to its debt or equity investors. It is the average cost of capital which includes debt and equity both.
The formula for calculating the WACC of any firm is as follows:
WACC = [(E/V *Re) + (D/V*Rd*(1-Tc)]
- E = Market Value of Total Equity
- D = Market Value of Total Debt
- V = E+D
- Re= Cost of Equity
- Rd= Cost of Debt
- Tc= Corporate Tax Rate
13. How would a Company’s Financial Statement be Affected by the Increase in Debt in the Company?
A financial analyst should be aware of the effects of the changes in debt or equity for a company. There would be some questions about these formats during the interview.
When a company increases debt, it would affect the balance sheet and cash flow both. In the balance sheet, long-term or short-term debt line item would increase by the same amount of raised debt. It will increase cash in cash flow under the financing section.
14. What are Cash Flow and its Various Sections?
Cash flow is a financial statement that explains the flow of money in a business. The cash flow statement describes how much money has been transferred to/from the company during a particular period of time. It also shows the cash balance at the end of the period.
There are three main sections/heads in a cash flow statement as per below:
- Cash from Operating Activities
- Cash from Investment Activities
- Cash from Financing Activities.
15. What is Deferred Tax Liability and Why is it Created?
Deferred tax liability is an obligation of payment in the future which is the difference between the amount of tax calculated according to income tax laws and the amount calculated according to financial statements if calculated on an accrual basis.
We prepare financial statements on the basis of accounting standards, but these accounting standards would differ from the rules assigned from Income tax authorities.
16. What are the Main Line Items in each Financial Statement?
There are three main financial statements during the financial modeling process, i.e. Balance Sheet, Income Statement and Cash Flow. The mainline items in each financial statement to focus on areas per below.
- Balance Sheet: Owner’s Equity, Long-Term, and Short-Term Debt, Current Liabilities, Current Assets, Fixed Assets.
- Income Statement: Income from Business activities, other income, Overheads, Depreciation & Amortization, Interest, and Tax.
- Cash Flow: Cash Flow from Operating Activities, cash flow from financing activities, cash flow from investing activities.
17. What is Depreciation? How does Depreciation Affect Financial Statements?
Depreciation is an important concept for accounting purposes. Depreciation is the reduction of the value of the assets over time. Depreciation is a non-cash expense, so it will affect the only balance sheet and income statement. It will not affect the cash flow statement.
Depreciation is an expense so it will affect the income statement by reducing net profit for the company. In the balance sheet, the amount of depreciation would be deducted from particular assets from the asset side.
18. What do you Mean by Negative Shareholder’s Equity?
Negative shareholder’s equity means negative balance in shareholder’s equity due to liabilities is more than assets. There could be the following reasons.
- The company is suffering losses for a longer period of time.
- More dividends were paid to its shareholders as compared to net profit.
19. What is the Difference between Deferred Revenue and Accounts Receivable?
Deferred revenue the amount of money received from the customer in which the goods or services have not been delivered yet, so the revenue for the same amount would not be recorded in the P&L. On the other side, the accounts receivable is the part of revenue, for which the goods or services have already been delivered but the amount for a particular invoice has not been paid by the customer.
An account receivable is an asset but deferred revenue is a liability.
20. A Company went Bankrupt even after having Positive EBITDA for the last 5 years, what are the Possibilities in this Case?
The situation of the bankruptcy of any company doesn’t depend on EBITDA or any other section of the profit and loss account. Even a profitable company could go bankrupt if there is no cash in the bank. Cash flow is the main parameter to check of financial health with positive cash of the company. Following are the reason for a profitable company going bankrupt.
- Due to heavy capital expenditure which affects negatively cash flow, but doesn’t affect on EBITDA.
- The company is not able to recover the money from its debtors for long but has to clear its payable on time which means more cash outflow.
- There could be a high one-time charge like a legal or professional charge where the company is liable to pay at any cost, this could affect the cash flow in a negative way.
There could be other various reasons for this case which will reduce cash in the company very quickly which doesn’t affect its profit and loss accounts.
This has been a guide to Financial Modeling Interview Questions. Here we discuss the Introduction and the Top 20 Financial Modeling Interview Questions with Answers. You can also go through our other suggested articles to learn more –