Most Common Interview Questions - CFI

When do you capitalize rather than expense a purchase?

If the purchase will be used in the business for more than one year, it is capitalized and depreciated according to the company's accounting policies.

When should a company consider issuing debt instead of equity?

A company should always optimize its capital structure. If it has taxable income, then it can benefit from the tax shield of issuing debt. If the firm has immediately steady cash flows and is able to make the required interest payments, then it may make sense to issue debt if it lowers the company's weighted average cost of capital.

"What is the average Price/Earnings PE ratio for the S&P 500 Index?"

About 15-20 times, the PE ratio varies by industry and period in the cycle.

A company has learned that due to a new accounting rule, it can start capitalizing R&D costs instead of expensing them. This question has four parts to it: Part I) What is the impact on the company's EBITDA? Part II) What is the impact on the company's Net Income? Part III) What is the impact on the company's cash flow? Part IV) What is the impact on the company's valuation?

Answer: Part I) EBITDA increases by the exact amount of R&D expense that is capitalized. Part II) Net Income increases, and the amount depends on the depreciation method and tax treatment. Part III) Cash flow is almost unimpacted - however, cash taxes may be different due to changes in depreciation expense, and therefore cash flow could be slightly different. Part IV) Valuation is essentially constant - except for the cash taxes impact/timing impact on the net present value (NPV) of cash flows.

If I could use only one statement to review the overall health of a company, which statement would I use and why?

Cash is king. The statement of cash flows gives a true picture of how much cash the company is generating. Ironically, it often gets the least attention. You can probably pick a different answer for this question, but you need to provide a good justification (e.g. the balance sheet because assets are the true driver of cash flow; or the income statement because it shows the earning power and profitability of a company on a smoothed out accrual basis).

"Which is cheaper debt or equity? Why?"

Debt because: It is paid before equity / may have security. Ranks ahead on liquidation

Which is cheaper, debt or equity?

Debt is cheaper because it is paid before equity and has collateral backing it. Debt ranks ahead of equity on liquidation of the business. There are pros and cons to financing with debt vs equity that a business needs to consider. It is not automatically better to use debt financing simply because it's cheaper. A good answer to the question may highlight the tradeoffs, if there is any followup required. Learn more about the cost of debt and cost of equity.

"List the main components of WACC (i.e. Weighted Average Cost of Capital)."

Debt, Equity, Tax, Beta

"What happens to Earnings Per Share (EPS) if a company decides to issue debt to buy back shares?"

Issuance of debt increases after-tax interest expense which lowers EPS. Repurchase of shares reduces the number of shares outstanding which increases EPS. Whether it increases or decreases EPS depends on the net impact of the above two points.

What does negative working capital mean?

Negative working capital is common in some industries such as grocery retail and the restaurant business. For a grocery store, customers pay upfront, inventory moves relatively quickly, but suppliers often give 30 days (or more) credit. This means that the company receives cash from customers before it needs the cash to pay suppliers. Negative working capital is a sign of efficiency in businesses with low inventory and accounts receivable. In other situations, negative working capital may signal a company is facing financial trouble if it doesn't have enough cash to pay its current liabilities. In this answer to this interview question, it's important to consider the company's normal working capital cycle.

What happens on the income statement if inventory goes up by $10?

Nothing. This is a trick question - only the balance sheet and cash flow statements are impacted by the purchasing of inventory.

Walk me through the three financial statements.

The balance sheet shows a company's assets, its liabilities, and shareholders' equity (put another way: what it owns, what it owes, and its net worth). The income statement outlines the company's revenues, expenses, and net income. The cash flow statement shows cash inflows and outflows from three areas: operating activities, investing activities, and financing activities.

"What makes a good financial model?"

The best financial models are clearly laid out, identify all the key drivers of the business, are accurate and precise yet not overly complicated, can handle dynamic scenarios, and have built-in sensitivity analysis and error checking.

How do you record PP&E and why is this important?

There are essentially four areas to consider when accounting for Property, Plant & Equipment (PP&E) on the balance sheet: (I) initial purchase, (II) depreciation, (III) additions (capital expenditures), and (IV) dispositions. In addition to these four, you may also have to consider revaluation. For many businesses, PP&E is the main capital asset that generates revenue, profitability, and cash flow.

Why would two companies merge? What major factors drive mergers and acquisitions?

There are many reasons companies go through the M&A process: to achieve synergies (cost savings), enter new markets, gain new technology, eliminate a competitor, and because it's "accretive" to financial metrics. Learn more about accretion/dilution in M&A. [Note: Social reasons are important too, but you have to be careful about mentioning them, depending on who you're interviewing with. These include: ego, empire building, and to justify higher executive compensation.]

"When should a company consider issuing debt instead of equity?"

There are many reasons to issue debt instead of equity: (1) It is a less risky and cheaper source of financing compared to issuing equity; (2) If the company has taxable income, issuing debt provides the benefit of tax shields; (3) If the firm has immediately steady cash flows and is able to make their interest payments; (4) higher financial leverage helps maximize the return on invested capital; (5) when issuing debt yields a lower weighted cost of capital (WACC) than issuing equity.

"How would you value a company?"

There are three common valuation methods used in IB: 1) The multiples approach (also called "comps"), in which you multiply the earnings of a company by the P/E ratio of the industry in which it competes (and other ratios). 2) Transactions approach (also called "precedents"), where you compare the company to other companies that have recently sold/been acquired in that industry. 3) The Discounted Cash Flow approach, in which you discount the values of future cash flows back to the present.

How does an inventory write-down affect the three financial statements?

This is a classic finance interview question. On the balance sheet, the asset account of inventory is reduced by the amount of the write-down, and so is shareholders' equity. The income statement is hit with an expense in either cost of goods sold (COGS) or a separate line item for the amount of the write-down, reducing net income. On the cash flow statement, the write-down is added back to cash from operating activities, as it's a non-cash expense (but must not be double counted in the changes of non-cash working capital). Read more about an inventory write-down.

"How do you calculate the WACC?"

This is calculated by taking the proportion of debt to total capital, times the debt rate, times one minus the effective tax rate, plus the proportion of equity to capital, times the required return on equity.

If you were CFO of our company, what would keep you up at night?

This is one of the great finance interview questions. Step back and give a high-level overview of the company's current financial position, or the position of companies in that industry in general. Highlight something on each of the three financial statements. Income statement: growth rates, margins, and profitability. Balance sheet: liquidity, capital assets, credit metrics, liquidity ratios, leverage, return on assest (ROA), and return on equity (ROE). Cash flow statement: short-term and long-term cash flow profile, any need to raise money or return capital to shareholders. Non-financial statement: company culture, government regulation, conditions in the capital markets.

How do you calculate the WACC?

WACC (stands for Weighted Average Cost of Capital) is calculated by taking the percentage of debt to total capital, multiplied by the debt interest rate, multiplied by one minus the effective tax rate, plus the percentage of equity to capital, multiplied by the required return on equity. Learn more in CFI's free Guide to Understanding WACC.

What is working capital?

Working capital is typically defined as current assets minus current liabilities. In banking, working capital is normally defined more narrowly as current assets (excluding cash) less current liabilities (excluding interest-bearing debt). Sometimes its even more narrowly defined as accounts receivable plus inventory minus accounts payable. By knowing all three of these definitions you can provide a very thorough answer.

"You have the opportunity to purchase a series of future cash flows that are $200 in perpetuity. The total cost of capital is 10%, how much are you prepared to pay today?"

[Note: Value = Cash Flow / WACC]. $2,000, because: $200 / 10% = $2,000 (i.e. 10x)