Financial Modeling Interview Questions Bank & Guide

If you are currently preparing for interviews in finance, related to financial modeling then you are at the right place! Finance interviews are often mis-understood, due to the jargons used. This might lead you to think, “I need to prepare for this job and that job specifically”. The reality is far from this, in fact I will break this down for you, so that you exactly know, the goal. Also I will share the High probability financial Modeling interview question bank also in this discussion.

I have analysed close to 10,000 interviews, from various source including a large chunk through our own placement services that we provide at Mentor Me’s financial modeling program. We can safely break down, the interviewing approach into

  • Fundamental
  • Job specific

Fundamental means, no matter what job you apply in finance types of questions. Like how do you calculate FCFE or FCFF? What is WACC?.

Job Specific means, additional basic awareness of domain. For example in a FP&A job interview, you are expected to know how to organise data and create insights on financial performance. That would be very different for a equity research job, where someone might be interested in your common sense approach to research itself.

So lets get started with top 10 fundamental interview finance questions first and then move to job specific questions.

Top 20 Fundamental Financial Modeling Interview Questions

Its very or I would say non negotiable to ace the fundamental questions, you ain’t going to be able to move any close to that job without this.

Financial Statements

Financial statements form the basic ground on which you play or may be an easy way to understand- the sport itself. You can’t be expected to become a wizard without knowing the sport itself.

What are financial statements and how are they interlinked to each other?

Income statement, Balance sheet and cash flow statement

Second part to the question is the relation ship between them, this is where candidates usually do not give a very confident answer.

Now wait and think about this, there are two parts to the questions. First is what are the financial statements?

source:https://corporatefinanceinstitute.com/
  1. So now the best answer based on the infographic that you see above is to explain very simply. The three financial statements are linked basis, the three ways of measuring business. Performance, status till date, and performance in cash.
  2. Hence the Income statement basically runs on the philosophy of  Revenue-Expenses= Profit
  3. The profit if, it gets left after dividends goes to retained earnings and at the same time a counter entry might be in accounts receivable or cash. Depending on whether it was cash revenue or credit revenue.
  4. Just like profit and retained earnings are linked, there are various other line items which are linked to balance sheet. For example cost of goods sold is linked to inventory
  5. The cash flow on the other hand is like a reconciliation of Income statement to cash by using the changes in balance sheet items.
  6. For example: If we sold 5 items worth $10, but the buyer would be us in the future then $50 gets booked in revenue( basis the accrual system of accounting). However in cash flow statement revenue needs to be converted to cash.
  7. So we take the $50 and find what changed in accounts receivable(credit sales). Hence if the credit sales in the previous year was $10 and in the current year is $60. That means the change is $-50. So the cash revenue =$50(Income statement)- ( $10-$50) change in accounts receivable.
  8. Such reconciliations are done for three different parts of business, namely. Operating, financial & investing activities of the business.

How do you calculate FCFF & FCFE with various line items of Income statements and state its use?

This is a  big one to impress upon the interviewer, but perceived very difficulty by candidates. The reason why, I feel is because you are trying to perceive financial statements, as financial statements. If for a second you stop doing that, and look at business from a very common sense perspective. Then you can start enjoying this.

  1. Free cash flow means, cash of business which is surplus after taking into consideration all the business activities but.
  2. The cash flow can be seen from two perspectives. Are you a debt investor or an equity investor.
  3. If it’s a debt investor then the cash flow that is relevant is the cash before repayment of princinpal and interest
  4. If its an equity investor then the cash flow that is relevant is the cash after interest. Those are the basic principles to start with.
  5. FCFE from Net Income: Net Income+ Depreciation +-( Changes in working capital)- capital expenditure(investments)- repayment of debt(periodic).
  6. So now try to see what exactly we have done the first part Net Income+ Depreciation +-(Changes in working capita). That is basically revenue converted to cash? Eh. That makes sense. So the idea is to first get operating cash.
  7. Second part of the formula- capital expenditure. Now you can really pack your bags and run away with the money. Can you? You also had some investments to do.
  8. Finally, the bank guys aren’t going to let you through without you paid their interest and principal ( a note here- interest was already reduced in net income & even if it was accrued then that takes care of itself in changes in wc)
  9. What’s left is the cash available to the equity investors.
  • FCFF from EBIT. Just like net income, why did we take EBIT? Because remember this is the cash flow for both the debt and equity investor. So the interest is actually the cash flow available for debt investor.
    1. EBIT (1- tax rate)+ Depreciation+- changes in wc – capex
    2. Why the tax because you have to pay the tax period.
    3. The only thing that changed after that for FCFF was?
    4. We didn’t reduce debt repayment or raising.
  • Now the part of deriving it from Other line items. Remember here! We are trying to find cash flow. So no need to remember the formulas. Just apply the logic.

What are the various revenue recognition methods and demonstrate its use?

  1. Revenue recognition can be divided in to regular and special cases. Under normal circumstances, we use what is called the accrual method.
  2. Special cases include percentage completion method, cost recovery method, and completed contract method.
  3. These methods are used in different cases like
    • Construction real estate companies. Since usually the acquisition, construction and sale of real estate projects can take multiple years. The revenue can be recognised basis the percentage of the completion of the project.  This is an aggressive method of revenue recognition.
    • Completed contract method: In this method no revenue is recognised until all the construction is completed. This is the most conservative method
    • Cost recovery method- In this method, revenue is recognised up to the costs incurred during the profit. Resulting in zero profit. This method is used usually in case of instalment sales.

Excel

Basic level of excel ability is of paramount importance, since this is where you do the work. No one will expect you to be VBA coder, but good enough so that they don’t have to baby sit you with basic functions

Explain how vlook and Index(match) differ & When you would use it?

V look up or vertical look up function & Index match are both used to find the related data, basis some field data point you have.

  • If you check the above data set, the data firstly flows from top to down i.e vertical. Hence vlook up gets used.
    • Second we take customer number(3604-2407), as the source of finding profit.
    • So vlook up function asks for three things
      • Look up value – 3604-2407
      • Table array- the place where you are looking. Now this is the difference between the two functions. Table array needs to be selected to make sure the source data col, is to the left most side of the selection, followed by the numeric index position of the finding data. The third coloum is where the profit lies.

While with index and match removes this constraint and you don’t have the constraint of left most side selection. You can check out the below image

Which function can we use, if we want to test the model sensitivity to various given assumptions?

This question will not be a deal breaker but as a interviewer myself I would probably rate you a beginner.

  • Sensitivity analysis can be done using the data table function in the Data Ribboon> What if Analysis > Data table
    • Data table is an array function and thus is hugely useful to test the model scenarios.
    • A Data table can be created by creating 2 x 2 Matrix of the assumptions to be tested. For example in a very basic table, we could test the interest rate & tax rate effect on profitability
    • Hence in the 2 x 2 Matrix interest rate and tax rate become the rows and col. So we can create various scenarios of interest and tax rate
    • To the side of the matrix we need to link the original profit calculation, which tells excel that this is the calculation which needs to be replicated by changing the two assumptions
    • Its important to note, that this won’t work unless your calculation and model is linked and no hard coding is done.

If you don’t know how to make a data table then you can refer to this tutorial here: https://mentormecareers.com/free-excel-course/

What is a circular reference?

A typical question to test, whether you understand how calculations actually work on excel.

  • Circular reference is basically an error caused when a calculation is performed linking its self. May sound confusion but let me show you below

  • Its important to understand not just what is circular reference but how to correct this.

Wait wasn’t it an error? So you mean to say, we use circular calculation?

  • Yes in fact a lot of models would be difficult to calculate if it wasn’t for circular calculation feature of excel.
    • Let me give you an example: Lets say you took a loan $100 with interest rate of 5% compounded annually. However you can’t pay the interest for 3 years. So what would would be the loan accrued until 3 years.

Capital Budgeting & Valuation

Finance jobs and particularly, jobs related to financial modeling skill requires you to understand financial mathematics. These are actually decision making benchmarks. For example: Deciding the investment buy or sell decision.

What are the various return measures, which are used in financial calculations and their uses?

The question is asking the return calculation methods, and there are mainly two approaches

  • Even cash flows
  • Uneven cash flows

Even Cash Flow Method

When we are dealing with decision making related to stock market performance or a mutual fund investment, then there is a particular entry point and an exit point

For example: You bought a stock at $10 in 2022 and sold it in lets say at $45 in three years. Then what is the return generated?

Hence there are only two points we are concerned with the entry at $10 and exit at $45 within 3 years. So in this case we can use the rate(CAGR) formula

Rate = (FV/PV)^(1/n)-1

CAGR

This can also be done in excel using the rate function: Just type =rate( put all the expected details)

Uneven Cash flow method

However in regular cases of start ups, the returns are not calculated in the same method because you really don’t buy the business you are starting and don’t really exit the business by selling ( you can but it’s too assumptions).

  • In such cases we are more concerned with the initial investment to start the business
  • The Free cashflow generated during lets say 4-5 years of the forecasting
  • Selling of assets and shutting down the business at the end

In these cases we use what is called “ Internal rate of Return” & “Net present value” Method.

Why do we use that?

Take an example: lets you start a business of manufacturing bricks, for that you create a factory and invest about $10,000. In the consecutive years you get $5000, $10000, $4000 as free cash flows.

How would you calculate rate of return based on the previous method discussed above?

Hence what IRR, does is we try to estimate the rate of return based on the logic that there must be some rate, which can make NPV zero( Initial Investment- Future cash flows).

  • However IRR has its problems, it assumes that we reinvest the surplus at IRR
  • It considers everything happens sequentially

You can learn how to calculate this with a model here: Learn Financial Modeling With A template

If someone is ready to give $1000 Every year forever, in exchange for you paying him $5000 today. Considering that there is a inflation of 6%. Will you accept this? If yes why and if no why?

This question will prove whether you understand time value of money in its intended way or not.

If you are answer is “Yes”, then you are wrong.

Create an excel with $100 And Find the PV like shown below and see for yourself

How do you value a company based on DCF( Discounted Cash flow)?

Very much a continuation of the financial mathematics, based on the present value concepts.

We can value a company using DCF, by first forecasting the free cash flow of the company

  • FCFF- To find the enterprise Value
  • FCFE- To find the equity value

Usually we use FCFF because, it can also be used to find the acquisition value. When you acquire a company you pay the enterprise value.

We then estimate the cost of capital and cost of equity for the company based on the method chosen. If we are using FCFF, then we use WACC (Weighted average cost of capital), else we use Cost of equity ( Derived from CAPM)

                      We discount the cashflow back to zero based on the discounting rate( either WACC or Ke        . Also since we are discounting only the forecasted period, but the business is a going concern hence we use the concept of Gordon growth model (Very similar to the present value of $100 example taken above).

The present value thus, has two parts

  • Explicit Forecasted Present value
  • Perpetual growth

Lets take an example and it will be more clear:

Lets say we are hypothetically valuing Infosys. Its FCFE for 3 years( Forecasted period) is as follows

  • $5000
  • $6500
  • $10000
  • Ke: 12%
  • Perpetual Growth rate: 5%
  • No of shares= 1000
  • CMP:$10

Check out the calculation below.

That concludes the most fundamental questions and types of questions you might be expected in finance interview. I am not saying these are the only one’s but I am referring to the type.

I will attach a question bank at the end, so you can refer and solve them in your own time.

Moving into now job specific questions!

Job Specific Financial Modeling interview questions

Now here’s the thing, you have to keep your eyes and ears open when you are applying. Don’t just give interview attempts, without even realising what role are we talking about.

So given that you have seen the job description correctly, let me discuss a couple of questions in each section.

Investment banking & Equity Research associate

How would you value a company that has negative cash flows?

Quite a practical question. The interviewer is trying to test, if you have spend enough time spending on practical cases.

You can actually value a company with even negative cashflows but not really by DCF. You can do that by using relative valuation. Some companies might be negative because of their growth phase, hence doesn’t really mean that the company has no value.

There are multiple approaches available:

  • Do valuation based on P/E, EV/EBITDA etc on profitable companies and then try to adjust it to estimate the value of the negative cash flow company
  • You could also do the same with DCF, and try to predict the profitable phase.
  • You can do asset based valuation, so no cash flow needed.

Which ratios will you use while doing financial analysis?

This should be straightforward but be careful not just give a lazy answer. You can follow up you answer with a question

Can you tell what the purpose is?

Lets say he says filtering based on the highest return performance. Then you can punch your way forward by mentioning

  • Return on Equity
  • Return on capital

ROE and ROC are very important ratios for filtration, because any company consistently performing over and above 15% ROC & ROE is likely also to continue to perform better.

What is revenue driver? Tell me your approach to finding the revenue driver for a grocery store?

This is the trick to test your logical bent.

Revenue drivers are important, very important in equity research. You can’t really understand a business, if you don’t have the ability to understand the two most important factors behind the revenue

Price X Quantity

& No! The grocery store revenue driver is not Price of inventory X Quantity of inventory.

How can you really predict or forecast the inventory. Also how can you ever judge whether the goods are actually getting sold or not.  The simplest way to think about revenue drivers is to think, this way.

What is the similarity between a large super market and small grocery store?

Space!

Larger space, larger revenue. Hence area matters in a super market business. So how about we design the revenue driver as:

Revenue Per sq feet( That’s price) x Space

Now you can forecast the revenue of the grocery store by forecasting space or the revenue per sq feet( premium products staking will leading higher revenue per sq feet)

How would you forecast costs for a company?

Again similar approach but easier. Usually costs are easy to forecast except the main cost driver.

For example in case of the grocery store business, what do you think is the main source of cost?

Space rent! Yes! & the cost of inventory itself

However inventory is a function of space itself. So we can easily use common size analysis to find COGS as a % of sales. You would be surprised that the ratio actually remains stable for a long time

Forecasting other line items is pretty straight forward using common size analysis because they are always seen as % of sales. Apart from complex business structures. Which is way out of topic for now.

Credit Analyst

Credit analyst can be of many types. You could be a credit analyst for a rating agency or a bank.

Objective though is same, make sure we know that the other person pays us back.

Which are the most common ratios used in projects to ascertain the feasibility of the project?

Project finance is usually funded through debt and the banks want to know whether your business has the capability to repay. Hence practically they want to understand if your cashflows are going to be enough to cover the interest and principal payments

So the ratios we can use is

  • Debt Service coverage ratio
  • Interest Coverage Ratio
  • Pay back period
  • Discounted pay pack period
  • Profitability Index

Financial Planning & Analysis analyst

These are roles related to corporate finance, which means you work inside the company as apart of the finance function. So logically any analysis you would perform would be either to

  • Increase revenue
  • Increase efficiencies
  • Set target matrix

Hence this role needs you to have a very solid understanding of financial statements and logical bent of mind.

What is break even sales?

Break even sales is the minimum sales you would have to do, in order to cover your fixed costs. Its very important for a business to constantly know, whats the kind of minimum sales required to not shut down.

Hence here you need to understand what is variable cost and what is fixed costs. Variable costs include- salaries, raw materials etc. Fixed costs include rent, plant and machinery maintenance.

So divide the fixed costs by average revenue to find the break even sales

Can we increase sales by reducing head count?

Tricky question! In a normal laymans talk , this is impossible but if you think about the possibilities then it is.

Larger number of employees doesn’t mean good.  Higher number of employees can also mean, more costs of maintaining an employee.

It might be possible to increase revenue by incentivising a smaller number of employees and removing inefficient employees.

Why for example: Lets you had 10 employees and you were paying them $1000 in total. Out of which 5 employees are under performing on a major scale. The rest 5 star performers though feel under paid.

Hence we could pay each one of the 10% higher and saving $500. So you not only saved $500 but also may be increase the motivation of the star performers to perform at 100% capacity

Real estate valuation analyst

There are lot of companies now in India, giving this knowledge process service to companies abroad.

The difference in case of real estate valuation is that the most important things are the cash to cash return, net operating income, exit cap rates and acquisition rate. Rest everything works just like any other field

What is net operating Income?

Net operating income is EBIT in normal sense that’s all. The only difference in real estate is that we generally consider real estate maintenance expenses, tax etc

What is Exit cap rate?

In a very common sense level, this is similar to dividend yield. In dividend yield you were trying to find the income to price. Similary in real estate you change that to NOI/ Price.

Hence real estate companies talk in terms of 5%, 10%, 6% exit cap rate. There is no DCF that takes place in case of real estate.

At the start of the acquisition of the real estate property we are interested in at what exit cap rate can we exit this property later on.

ALLEN ARAVINDAN,CFA
ALLEN ARAVINDAN,CFA

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