100+ Technical Finance Interview Questions You Need to Know

There are two methods by which cash flow statements are organized: Direct and Indirect.

The most common approach is the indirect method, whereby the cash flow statement is broken out into 3 sections:

1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities

Together they add up to the net change in cash during the period.

Cash from operating activities starts with net income and adds back non-cash expenses like depreciation and amortization, stock based compensation as well as changes in working capital to arrive at cash flow from operations.

Cash from investing activities captures capital expenditures and other investing activities like purchases of intangible assets or financial investments.

Lastly, cash from financing activities captures cash inflows from borrowing and stock issuances and outflows from dividends, debt repayment and share repurchases.

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The three financial statements are the

1. Income statement
2. Balance sheet
3. Cash flow statement

The income statement shows the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year.

Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity.

Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end-of-period cash balance. It typically begins with net income and is then adjusted for various non-cash items and working capital changes to arrive at cash from operations. Cash from investing and financing activities are then added to cash flow from operations to arrive at net change in cash for the year.

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The income statement shows a company's profitability over a period, usually quarterly or annually.

The income statement starts with revenues generated during the period and subtracts operating expenses like cost of goods sold and selling, general and administrative expenses (SG&A) to arrive at operating income.

Then, non-operating expenses like interest expense are subtracted and any non-operating income is added to arrive at pre-tax income. Then, tax expense is removed to arrive at net income, which is the bottom line.

Below the income statement, you will also find the companies weighted average shares outstanding and earnings per share for the period.

The balance sheet shows a company’s assets, liabilities and equity sections at a point in time. Assets are organized in order of liquidity, with a section for “current assets” representing assets that can generally be converted into cash within a year. These include cash itself, along with accounts receivable and inventories. Common long-term assets include property, plant and equipment, intangible assets and goodwill.

Liabilities are also organized in order of when they are due – current liabilities include accounts payable and short-term debt, while long-term liabilities include long-term debt. Lastly, the equity section shows a company’s common stock, treasury stock and retained earnings.  Assets represent what a company owns and must always equal liabilities and equity – which represent the way assets were funded.

Note: This question is similar to "walk me through the 3 financial statements" but focuses on the connections between the three statements.  It's quite possible that you may be asked in an interview to define three statements as well as to describe how they're connected in one answer. 

The financial statements are very interconnected, both directly and indirectly.

The income statement is directly connected to the balance sheet through retained earnings. Specifically, net income (the bottom line in the income statement) flows through retained earnings as an increase each period less dividends issued during the period.

The offsetting balance sheet adjustments to the increase in retained earnings impacts a variety of line items on the balance sheet, including cash, working capital and fixed assets.

The cash flow statement is connected to the income statement through net income as well, which is the starting line of the cash flow statement.

Lastly, the cash flow statement is connected to the balance sheet because the cash impact of changes in balance sheet line items like working capital, PP&E (through capex), debt, equity and treasury stock are all reflected in the cash flow statement. In addition, the final calculation in the cash flow statement - net change in cash - is directly connected to balance sheet, as it grows the beginning of the period cash balance to arrive at the end of period cash balance on the balance sheet.

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Enterprise value / EBITDA multiples are probably the most common, followed by EV/EBIT and P/E. There are several others that are more industry- and company-specific. For example, P/B ratios are used to value financial institutions and EV/Revenue multiples are used to value companies with negative earnings.

While there are a variety of methods for valuing companies, they largely fall under two categories:

The first is intrinsic valuation, where the value of a business is arrived at by looking at the ability of that business to generate cash flows. The discounted cash flow method is the most common type of intrinsic valuation and says that the value of business equals the present value of its future free cash flows.

The second is relative valuation, where the value of a business is arrived at by looking at comparable companies and applying the average or median valuation multiples derived from the peer group – often EV/EBITDA, P/E, or some other relevant multiple to value the target company. This valuation can be done by looking at the multiples of comparable public companies using their current market values, which is called trading comps, or by looking at the multiples of comparable companies that have been recently acquired, which is called deal comps.

A company buys back shares primarily as a way to move cash from the company’s balance sheet to shareholders, similar to issuing dividends. The primary difference is that instead of shareholders receiving cash (in the case of dividends), a share repurchase removes shareholders, leaving a smaller shareholder base.

The impact on share price is theoretically neutral – as long as shares are priced correctly, a share buyback should not lead to a change in share price because while the share count (denominator) is reduced, the equity value is also reduced by the now lower company cash balances. That said, share buybacks can impact share price movement positively or negatively if they are perceived as a new signal about the company’s future behavior or growth prospects.

For example, cash-rich but otherwise risky companies could see artificially low share prices if investors are discounting that cash. In this case, a buyback should lead to a higher share price, as the upward share price impact of a lower denominator is greater than the downward share price impact of a lower equity value numerator.

Conversely, if shareholders view the buyback as a signal that the company’s investment prospects aren’t great (otherwise, why not pump the cash into investments?), the denominator impact will be more than offset by a lower equity value (due to lower cash AND lower perceived growth and investment prospects).

On the financial statements, a $100 million share buyback would be treated as follows:

• Cash is credited by $100 million
• Treasury stock is debited by $100 million

An M&A model takes two companies and combines them into one entity. First, assumptions need to be made about the purchase price and any other uses of funds such as refinancing target debt and paying transaction and financing fees). Then, assumptions about the sources of funds need to be made – will the acquirer pay for the acquisition using cash, take on additional debt or issue equity. Once those basic assumptions are in place, the acquirer’s balance sheet is adjusted to reflect the consolidation of the target.

Certain line items – like working capital can simply be lumped together. Others need a little more analysis – for example, a major adjustment to the combined target and acquirer balance sheet involves the calculation of incremental goodwill created in the transaction, which involves making assumptions about asset write ups, and deferred taxes created or eliminated.

Lastly, deal-related borrowing and pay-down, cash used in the transaction, and the elimination of target equity all need to be reflected.

In addition, the income statements are combined to determine the combined (“pro forma”) accretion/dilution in EPS. This can be done as a bottom’s up analysis – starting from the buyer’s and seller’s standalone EPS and adjusting to reflect incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write ups.

Alternatively, the accretion dilution can be a top down, whereby the two income statements are combined starting with revenue and working its way down to expenses, while making the deal related adjustments.

The answer depends on several factors.

From the buyer’s perspective, when the buyer’s PE ratio is significantly higher than the target’s, a stock transaction will be accretive which is an important consideration for buyers and may tilt the decision towards stock. When considering debt, the buyer’s access to debt financing and cost of debt (interest rates) will influence the buyer’s willingness to finance a transaction with debt. In addition, the buyer will analyze the deal’s impact to its existing capital structure, credit rating and credit stats.

From the seller’s perspective, a seller will generally prefer cash (i.e. debt financing) over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration.

From a valuation perspective, an accretive deal is not necessarily indicative of value creation for the acquirer and vice versa for dilutive deals. However, significant accretion or dilution is often perceived by buyers (and public company buyers in particular) as an indication of potential investor reaction to the transaction.

Specifically, dilutive deals are feared by buyers to lead to decline in their share price after announcement. This fear is rooted in the notion that investors will apply the pre-deal PE ratio to the now-lower pro forma EPS. These concerns, while quite valid when viewed through the prism of buyers’ short-term concerns about meeting EPS targets, or not actually relevant to whether a deal actually creates long term value for the acquiring company’s shareholders, which is a function of intrinsic value of the newly combined company.

A leveraged buyout is similar to purchasing a house. The purchase price is funded partially by an equity investor – which is the private equity firm also called the financial sponsor. The remainder is funded through loans and bonds that the financial sponsor secures ahead of the transaction.

Once the sponsors gain control of the company, they get to work on streamlining the business – which usually means restructuring, layoffs and asset sales with the goal of making the company more efficient at generating cash flow so that the large debt burden can be slowly paid down.

The investment horizon for sponsors is 5-7 years, at which point they hope to be able to ‘exit’ by either 1) Selling the company to another private equity firm or strategic acquirer 2) Taking the company public, or 3) Recapitalizing the business by taking on additional debt and issuing themselves a dividend with the debt proceeds. Accomplishing this can provide financial sponsors with a high internal rate of return. Financial sponsors usually target returns of 15-25% when considering making an investment.

The keys to making this work include:

• Acquiring the company at a low multiple (“getting in cheap”)
• Successfully restructuring and increasing cash flows
• Selling at a high multiple

An LBO model analyzes the impact of a company buyout by financial sponsors using both its own equity as well as new borrowing as the two primary sources of capital. The specific impacts analyzed by the model include an equity valuation of the pre-LBO “oldco”, the IRR to the various new debt and equity capital providers, impacts on the company’s financial statements and ratios.

To build an LBO, start with identifying the uses of funds – how much oldco equity will be paid, any oldco debt that needs to get refinanced, as well as any fees. Based on this, make assumptions about the sources of funds: How much and the type of debt capital needs to be raised, with the residual being funded by sponsor equity.

Ideally, the operations are forecasted over 5-7 years (the expected holding period), and a complete 3 statement model is built so that the LBO debt assumptions correctly impact the income statement and cash flow statement.

In getting the correct cash flow forecasts, it is important to build a debt schedule that accurately modifies debt based on the flow of excess cash or deficits.

Next, exit assumptions need to be made – most notably around what the exit EV/EBITDA multiple will be. Based on this assumption and the existing state of the balance sheet at the presumed exit date, IRR and cash on cash returns can be estimated for the sponsors (and any debt providers as well).

Lastly, scenarios and sensitivity analysis can be added to provide users with different ways to look at the model’s output – one common sensitivity is to back into the implied oldco equity value based on explicit sponsor hurdle rates and/or operating assumptions.

Companies that make good LBO candidates have steady, predictable cash flows with little cyclicality, minimal ongoing capital expenditures and working capital investment requirements, perhaps with subsidiary businesses that can be immediately sold to help pay down debt.

While some features of loans and bonds can overlap, the key differences are that a loan is a private transaction between borrower and lender. The lender is either a single bank or a small syndicate of banks or institutional investors. The cost is often priced off LIBOR plus a spread, the loan is often secured by company assets and the terms are very strict (strict covenants), while the repayment of principal can happen over time or as a bullet payment at the end. Because of the collateral, earlier principal repayments and restrictions, loans are less risky for lenders and thus generally command lower interest rates than bonds.

Bonds, on the other hand, must be registered with the SEC and are thus public transactions. Because bonds are issued to institutional investors and then trade freely on the secondary bond market, the investor base is broad and diverse, comprised of a variety of institutional investors. Corporate bonds are usually priced as a fixed rate, with payments made semi-annually, with longer terms than loans, with a balloon payment at maturity. Bonds come with less restrictive covenants and are usually unsecured.  As a result, they are riskier for investors and thus command higher interest rates than loans.

Below is a debt cheat sheet:

The yield curve in general is just a plot of the relation between the yield and term of otherwise similar bonds. The treasury yield curve plots treasury bond yields across their terms. It’s the most common and widely used yield curve as it sets a “risk free” benchmark for other bonds (corporate, municipal, etc.).

A treasury yield curve is normally upward sloping because all else equal, an investor would prefer a 1-year, 3% bond than being locked into a 30-year, 3% bond.

However, investors’ expectations about future interest rates impact the slope as well. When investors think the Fed will raise interest rates in the future, investors will increase demand for short term treasuries to avoid getting locked into low but a soon-to-be higher long-term rate. This increase in relative demand for short term treasuries will lower short term yields and raise long term yields, creating a self-fulfilling prophecy.

Learn more about the yield curve:  Explain the yield curve to me like I'm an idiot

An inverted yield curve means that yields on longer maturities are lower than shorter maturities of otherwise comparable bonds, like treasuries.  Normally, yield curves are upward sloping as issuers must pay a premium to entice investors to keep their capital locked up for a longer term. When the yield curve inverts, it is usually a harbinger of an economic slowdown and recession. In fact the last 7 recessions were preceded by an inversion of the yield curve and it is considered a strong leading indicator by economists and investors alike.  The inversion happens as investors anticipate market interest rates to decline down the road (presumably because they expect a slowdown and thus expect monetary policy makers to eventually lower rates to stimulate the soon-to-be slowing economy) and thus prefer the safety of long term maturities at the current higher rates over investing in shorter maturities and having to re-invest at the lower expected future rates.

Read more: Explain the yield curve to me like I'm an idiot

REITs are “pass-throughs”, meaning REIT profits are not taxed on the corporate level, but rather pass through to the shareholder, who gets taxed at the individual level on the dividends issued by the REITs.

However, one of the key requirements for qualifying for this tax advantaged REIT status, is that at least 90% of the REIT’s profits must be distributed as dividends, so a REIT can’t hoard profits like a C Corp and not issue any dividends. Also, a REIT’s dividends are “non-qualified”, meaning they are taxed at the ordinary income (higher) tax rate than the capital gains (lower) tax rate. In contrast, C-corporations have a corporate level tax, followed by a second tax on dividends but those C-Corp dividends are qualified meaning, they are taxed at a lower capital gains tax.

Note: REITs do not pay corporate level taxes but REITs DO pay property taxes on the properties they own. These taxes are included as part of direct real estate expenses on a REITs income statement (see the NOI question)

On the income statement, rental income is the primary source of revenue. In addition, there may be ancillary income such as management fees which is included in revenue. The primary expenses include:

Direct real estate expenses: utilities, marketing & advertising, payroll, maintenance and property taxes.

Revenues less these direct expenses equal a REITs net operating income, whnich represents a REIT’s property-level profitability. Next, we subtract corporate overhead, G&A expenses and depreciation expense to get to GAAP operating profit. Under US GAAP, REITs usually have a ton of depreciation expense due to the asset intensive nature of their business (there’s no depreciation for REITs under IFRS).

Next we subtract interest expense which is usually large for REITs because REITs borrow a lot to finance their operations.

Lastly, REITs are constantly buying and selling real estate so there is usually significant income or loss from discontinued operations (along with hefty gains or losses on sales) reported below net income.

Net operating income (NOI) equals a REIT’s rental income less property-level real estate expenses such as utilities, marketing & advertising, payroll, maintenance and property taxes.

It is a measure of profit before depreciation, corporate level SG&A and interest expense. The NOI is important because it isolates property-level profitability, which enables comparisons across different properties or portfolios of companies, without noise of corporate level expenses or leverage. While not exactly the same, it is the closest thing REIT financials have to gross profit. NOI is the numerator used in the calculation of a REIT or real estate property’s cap rate.

Upstream, midstream and downstream (Utilities/power generation/coal are typically not included when discussing O&G).

• Upstream consists of Exploration and Production (E&P) companies, as well as Oil-Field Service (OFS) companies. OFS companies run drilling rigs, prepare seismic and geological/geophysical data to support E&Ps, which actually end up producing the oil and gas for sale.
• Midstream companies are primarily involved in the transportation (pipelines, rail, etc.) and storage of hydrocarbons (crude and refined product terminals, gas and NGL storage facilities). Processing of gas into natural gas liquids is also considered midstream, unlike refining of crude (see next bullet).
• Downstream typically refers to the refining of crude into motor gasoline (mogas), distillates and other products.