Financial Modelling

Financial modeling is the task of building an abstract representation of a real world financial situation. If you are a finance professionals, then you must check these interview questions which can help you to prepare for different finance roles.

Q.1 What do you understand by financial modelling?
Financial model is a tool that is usually built in Excel to forecast, or project, a business’ financial performance into the future. Such that the forecast is typically based on the company’s historical performance and requires preparing an income statement, balance sheet, cash flow statement, and supporting schedules referred as a “three statement model”. Such that from there, more advanced types of models can be built, like discounted cash flow analysis (DCF model), leveraged-buyout, mergers and acquisitions, and sensitivity analysis.
Q.2 What is the purpose of financial model ?
Primarily the output of a financial model is used for making decisions and performing financial analysis, either inside or outside of the company. When performing analysis inside a company, the executives use financial models to make decisions with reference to -
1. Raising capital (debt and/or equity)
2. Making acquisitions (businesses and/or assets)
3. Growing the business organically (e.g., opening new stores, entering new markets, etc.)
4. Selling or divesting assets and business units
5. Budgeting and forecasting (planning for the years ahead)
6. Capital allocation (prioritize which projects to invest in)
7. Valuing a business
Q.3 What is the process to build a financial model?
The steps involved in building a financial model are -
1. Historical results and assumptions
2. Construct the income statement
3. Construct the balance sheet
4. Build the supporting schedules
5. Complete the I/S and B/S
6. Construct the cash flow statement
7. Perform the DCF analysis
8. Sensitivity analysis and scenarios
9. Build charts and graphs
10. Stress test and audit
Q.4 What are the three most common financial modelling best practices?
The industry follows best practices in financial modelling, such that financial analysts can build financial models more efficiently and users are able to easily and quickly grasp important information when they look at the models.
1. Excel tips and tricks - Limit or eliminate the use of your mouse — keyboard shortcuts help speed up the process. Such that break complex calculations into simpler steps. Know the important Excel formulas and functions (INDEX MATCH MATCH, CHOOSE, VLOOKUP, etc.)
2. Formatting - Clearly distinguish between inputs (assumptions) and outputs (calculations or formulas) using formatting conventions — blue font for inputs and black font for formulas, shading, borders, etc.
3. Model layout and design - It is critical to structure a financial model in a logical, easy-to-follow design. This can be achieved by building the entire model on a single worksheet and using the group function to create sections.

Also it is a good practice to use the same color theme throughout the whole model to make it professional-looking.
Q.5 How would you define sensitivity analysis in Financial Modeling?
Sensitivity analysis is a defined tool used in financial modeling to analyze how different values of a set of independent variables impact a specific dependent variable under certain conditions. Therefore for instance a financial analyst may want to examine a company’s profit margin may be impacted when variables such as the cost of goods sold and labor costs change. He can perform a sensitivity analysis to test different sets of values for these variables and see how the profit margin changes accordingly.
Q.6 Which tools would you use in Excel to audit your model?
Some of the tools used in Excel to audit the model -
1. Model structure — This tool is used for separating inputs (constants only) from processing and outputs (formulas only), that can easily track the source of inputs and ensure that assumptions are consistent (this assumptions should be entered once only).
2. Go to special — Go to special function in Excel permits to highlight cells containing specific content, such as constants, formulas, and text. This tool helps to check whether all inputs are constants and all outputs are formulas.
3. Trace precedents and dependents — This tool is used for tracing precedents identifies what precedes the cell you would like to check (check which inputs are used in a formula) while tracing dependents identifies where an input cell flows into.
Q.7 Define Equity financing.
In this method, the company can raise comparatively more amount of funding as than debt financing. The financier would get some of the ownership of the company and offer funds as per the working capital requirement. Moreover, there is no monthly obligation of repayment of funds and no interest portion is to be added to the principal amount.
Q.8 How would you define Financial Modelling?
Well, financial modelling can be defined as a mathematical representation of a future financial statement in the form of a spreadsheet. This explains the plans for future revenue and expenses.
Q.9 What are the different kinds of Financial Statements?
. Balance Sheet . Income Statement . Cash Flow
Q.10 What is debt financing?
In this method, a company raises funds in the form of a loan which comes with an interest portion with it. So, the company would have a monthly obligation to repay it. The benefit 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 company and lender’s relationship ends.
Q.11 What is an investment?
Well, investment is the study of methods that are used by individuals in order to manage portfolios and provide financial planning.
Q.12 What is IRR?
IRR stands for Internal Rate of Return. It is one of the best techniques and broadly used in investing projects. IRR is the rate of return at which the NPV of all cash inflow or cash outflow of any project becomes zero.
Q.13 Define an Income Statement.
An income statement is also known as a profit and loss account. This is one of the major types of financial statements of the company which shows the revenue, expenses, and net profit or loss of the company at a specific period of time.
Q.14 What do you understand by the term working capital?
Working capital is basically the money available with any business for day-to-day operations. Working capital can be calculated by using the following formula: Working capital = Current Assets – Current Liabilities
Q.15 What is DCF?
DCF stands for Discounted Cash Flow. This is the best valuation technique of calculating the value of the firm at the time of acquisition or financing. In DCF, the net present value is calculated for future cash flows.
Q.16 What do you mean by cash flow?
Cash flow is a type of financial statement that represents the flow of cash in the company for a particular time period.
Q.17 What are the different sections in the Profit and Loss Account?
The 3 main sections in a profit & loss account are: • Income or Revenue section • Profit or Loss section • Overhead section
Q.18 What are the different kinds of financial ratios?

The 5 kinds of financial ratios are:

1. Liquidity ratios

2. Efficiency Ratios

3. Profitability Ratios

4. Market Valuation Ratios

5. Leverage Ratios

Q.19 What is NPV?
NPV is the acronym for Net Present Value. As the name suggests, it is used for calculating the present value of all cash flows that are generated from a project, cash flows could be negative or positive. So, it is the difference between the present value of cash inflow and cash outflow for a project.
Q.20 What Is The difference between NPV and XNPV?
The basic difference between NPV and XNPV is that NPV assumes that the cash flows come in equal time intervals whereas XNPV considers that the cash flows don’t come in equal time intervals.
Q.21 Can you define the meaning of goodwill?
We can define goodwill as the redundant value of cost price against the essential market value of the same. Moreover, goodwill qualifies in the category of intangible assets.
Q.22 Mention some ways to design a revenue schedule?

Some of the common ways are:

1. Sales growth

2. Unit volume, change in volume, average price and change in price

3. Inflationary and volume/ mix effects

4. Dollar market size and growth

5. Volume capacity, capacity utilization and average price

6. Unit market size and growth

7. Product availability and pricing

Q.23 Which ratios should we calculate for Financial Modeling?

The ratios that we should calculate for Financial Modelling are: 1

. Liquidity ratios

2. Return on Equity

3. Turnover Ratios

4. Return on Assets

5. Debt to Equity Ratio

Q.24 How do you consider stock options in financial models?
Well, stock options are used by many companies in order to incentivise their employees. The employees get an option to buy the stock at the Strike Price. In case, the market price is greater than the stock price, then the employee can exercise its options and profit from it. When the employees exercise their options, they pay the strike price to the company and get shares against each option, thereby increasing the number of shares.
Q.25 What are the basic concepts of finance?
The three main concepts are: Financial Management, Financial Markets and Institutions and Investment
Q.26 What are the two types of Financial Model layouts?

The two types of Financial Model layouts are:

1. Vertical Financial Model Layouts

2. Horizontal Financial model Layouts

Q.27 How is working capital calculated?
Working capital is calculated using the differences between current assets and current liabilities, containing the following accounts: (+) Cash (+) Accounts Receivable (+) Inventory (-) Accounts Payable
Q.28 Define expense models.
An expense model explains what expense categories are allowed on a specific type of work order.
Q.29 Explain quarterly forecasting.
Quarterly forecasting is the analysis of expenses and revenue that is predicted to be produced or incurred in the future.
Q.30 What are the main characteristics that define a good model?

The main characteristics that define a good model are:

  • Structured
  • Flexible
  • Transparent
  • Logical
Q.31 What is sensitivity analysis in financial modelling?
Sensitivity analysis is a tool of Excel. This enables us to quickly see what would be the result that we would get if we modify two variables of our model.
Q.32 What is a horizontal financial model?
Horizontal Financial model Layout is easier to setup with each module in a different sheet. Here the readability is high as we can name the individual tabs accordingly. The only problem is that there are numerous sheets to be interlinked.
Q.33 How do you record PP&E and why is this important?

The four important areas to consider when accounting for Property, Plant & Equipment (PP&E) on the balance sheet are:

  • initial purchase
  • depreciation
  • additions
  • dispositions
Q.34 What does negative working capital mean?
Negative working capital is common in industries like grocery retail and the restaurant business. For a grocery store, customers pay upfront, inventory moves relatively quickly, but suppliers usually gives 30 days credit. Hence, the company receives cash from customers before it needs the cash to pay suppliers.
Q.35 Mention one difference between a P&L statement and a balance sheet?
The balance sheet summarizes the financial position of a company for a particular point in time whereas the P&L statement shows the revenues and expenses during that set period of time.
Q.36 Why would two companies merge?
There are many reasons for companies to merge. These include achieving synergies, entering new markets, gaining new technology, eliminating a competitor, and also as it’s “accretive” to financial metrics.
Q.37 When do you capitalize rather than expense a purchase?
If the purchase is to be used in the business for more than a year then it is capitalized and depreciated according to the accounting policies of the company.
Q.38 What do the credit rating agencies do?
Rating agencies help in providing trust and confidence in financial markets by rating borrowers on their creditworthiness of outstanding debt obligations.
Q.39 What is free cash flow?
Free cash flow is equal to the cash from operations minus capital expenditures. Moreover, in financial modelling, unlevered free cash flow is used.
Q.40 What is the composite cost of capital?
The weighted average cost of capital shows the composite cost of capital. Parameters such as the debt, preferred stock and common stock are reflected in the eventualities of the composite cost of capital.
Q.41 What do you use for the discount rate in a DCF valuation?
We usually use the Weighted Average Cost of Capital i.e. WACC) as the discount rate. However, in case of forecasting free cash flows to equity, we use the cost of equity.
Q.42 What is the interest coverage ratio?
Interest coverage ratio is generally calculated as EBIT divided by interest expense. It is called the “times interest earned” ratio. The interest coverage ratio shows how easily a company can cover it’s interest expense with operating earnings before the subtraction of interest and taxes.
Q.43 What are adjustment entries?
The entries that are passed at the end of each accounting period are called the adjustment entries.
Q.44 What are the most common credit metrics banks look at?
The most common credit metrics consist of debt/equity, debt/EBITDA, fixed charge coverage, debt/capital , interest coverage, and tangible net worth.
Q.45 What is the LIBOR rate?
LIBOR is basically a standard interest rate at which global banks lend to one another for short term loans.
Q.46 What methods do you use to compare the liquidity, profitability, and credit history of a company?
The Current Ratio, Return on Assets (ROA), Debt/Equity, Return on Equity (ROE), Debt/Capital, and Interest Coverage ratios.
Q.47 How do you value a company?
Well, the common basis is DCF valuation / financial modelling and relative valuation methods using comparable public companies and precedent transactions.
Q.48 What type of person makes a good credit analyst?
A good credit analyst is someone who is detail-oriented, likes working independently , good with mathematics, enjoys research and analysis, and is good at financial modelling and financial analysis.
Q.49 What is cost accountancy?
Cost accountancy is the holistic presentation of cost control as well as other account figures so as to uphold the fairness of a particular venture and aid the prospects of a grounded managerial decision making.
Q.50 Can you define hedging?
Well, hedging is defined as an instrument to alleviate risks. Hedging corresponds to the essential purpose of insurance. However, what marks the difference between the two is that hedging is not concerned with augmenting profits but alleviating risks.
Q.51 How do you calculate the terminal value in a DCF valuation?
Terminal value is calculated with the use of either an exit multiple or the perpetual growth method.
Q.52 What is preference capital?
Preference capital is defined as the capital that carries preference over equity capital at the time of the payment of dividend and the winding up of the company.
Q.53 Can you highlight the purpose of a deferred tax liability?
A deferred tax liability comes into the view when the concerned amount of tax is shelled at a future date to the IRS. It can be summed up as the opposite of the deferred tax asset.
Q.54 What are the various techniques of company valuation?

The techniques or methods of determining the valuation of any company are:

  • Discounted Cashflow Method
  • Asset Approach
  • Market Value Business Valuation Method
  • Debt Financing
Q.55 What do you understand by the term debentures?
A debenture is a certificate of loan agreement furnished under the stamp of a company. The debenture holder is mandated to receive a fixed return as well as the principal amount at the time of the maturity of the debenture.
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