Investment Banking Questions and Answers
As you prepare for your investment banking interview, there is no certainty that particular questions will be asked. However, several topics are predominantly discussed during these interviews, which we would like you to get familiar with.
For almost every position in finance, and especially for investment banking positions, it is crucial to have a sound understanding of the main financial statements: the income statement, balance sheet and cash flow statement. You should be able to answer questions as to why these statements exist, what components they consist of, and what advantages each of the statements has. Moreover, and this is one of the most important points, you should be prepared to answer questions about how the three financial statements are linked.
When it comes to evaluating business ideas, you will often only have access to the financial statements. While they might give investors a good overview of the financial position of the company, they also tell the experienced reader whether a company has prepared for a sale by, for example, stopping investments in the maintenance of certain assets. Sometimes, particular investments could have been made only to “make the bride prettier”, e.g. by drastically prolonging the payment of invoices, to the disadvantage of supplier relations.
In an investment banking interview, your interviewer will most likely touch base on your understanding of these points. Therefore, make sure you come prepared.
For that very purpose, we have created guides on the income statement, balance sheet and cash flow statement – make sure you give them a proper read before tackling the questions below!
Section 1 - General Investment Banking Interview Questions
Section 2 - Investment Banking Technical Interview Questions
Which financial statements do you know?
The three major financial statements
(1) Income Statement/Profit and Loss Statement
(2) Balance Sheet
(3) Cash Flow Statement
Other financial statements
(4) Depreciation Schedule
(5) Debt Schedule
(6) Working Capital Schedule
Walk me through a profit and loss (income) statement.
The P&L measures a company’s profits and losses in a certain period. It is one of the three major financial statements next to the cash flow statement and the balance sheet and is compulsory for all companies due to tax reasons.
According to IFRS, a company can structure its P&L in line with the “function of expense” or “nature of expense” method. The “function of expense” method allocates costs to different functions, e.g. research & development and administrative. The “nature of expense” method lists the costs according to what their nature is, for example, depreciation and salaries.
For larger companies, the allocation of costs to functions is predominant.
In brief: The P&L starts with revenues of the company. Afterward, COGS will be deducted, which are direct costs of the products or services – this brings us to the gross margin. Following that, operating expenses (SG&A, R&D, marketing) are deducted, and other income added, which will result in EBITDA. To get from EBITDA to net income, D&A, interest and tax must be subtracted.
For more details on the P&L, please refer to the income statement guide.
Walk me through a balance sheet.
The balance sheet shows a snapshot of a company’s financial positions at a given point in time. It is split up into the following three major sections: assets, liabilities and shareholders’ equity. The sum of a company’s assets must always equal the sum of liabilities and equity.
Assets = Liabilities + Equity
For US GAAP, the assets are shown in the ascending order of liquidity, meaning the amount of time it usually takes to sell and convert them to cash. Therefore, the balance sheet will always start with current assets, and especially cash and cash-like items, followed by accounts receivables, inventory, fixed assets etc. The liabilities are usually ordered by their due date, starting with the short-term, followed by long-term debt.
For IFRS, this is exactly the opposite. Assets are ordered in descending time necessary to liquidate them, i.e. long-term assets first down to cash. The equity and liabilities side first start with equity down to short term debt.
For an illustration, please refer to the balance sheets below. For more detailed information about the balance sheet, please refer to our balance sheet guide.
Walk me through a cash flow statement.
A cash flow statement measures how much cash a company has spent or produced over a certain period. Although an income statement shows the profitability of a business, it also includes non-cash items.
As an example: If a company sells items worth €2m, thereof €1m on credit and €1m against cash payment, the income statement will show revenues of €2m, however, on the cash flow statement we would need to reduce the net income by €1m (the credit portion) as we have not yet received the full (cash) payment. Vice versa, if we have certain expenses on the income statement that have not yet been paid, we would need to add them back to net income on the cash flow statement as we have not actually paid them using our cash reserves.
To sum up, the cash flow statement aims at showing how much cash a company has actually generated, which is split into the following three segments:
- Cash flow from operating activities – shows how much cash has been generated from net income
- Cash flow from investing activities – represents the amount of cash being received or spend through investments (selling or investing in assets, businesses, securities or other investments)
- Cash flow from financing activities – shows the portion of cash generated from equity or debt, e.g. raising or paying back debt, raising or buying back equity, distributing dividends to shareholders etc.
The sum of these three is the total amount of cash generated/received in a given period. For more detailed information about the cash flow statement, please refer to our cash flow statement guide.
What is working capital? Which items does it include?
Working capital or net working capital is defined as the difference between current assets and current liabilities. When talking about working capital and also for financial modeling purposes, people typically refer to “operating working capital” or “OWC”, which would be the difference between non-cash current assets and non-interest-bearing current liabilities. It is a liquidity and efficiency measure that shows how much funding the daily operations of a business need. All the components of working capital can be found on the balance sheet.
- Accounts receivable
- Prepaid expenses
- Other current assets
- Accounts payable
- Accrued expenses
- Other current liabilities
A positive OWC figure means that the company has sufficient funds to cover its short-term liabilities. Vice versa, a negative working capital figure means that the company’s liabilities are high. However, that doesn’t necessarily mean that a very high OWC is what a company should aim for, while a highly negative OWC should be avoided. A high OWC could also mean that the company’s customers are not paying their invoices in a timely manner, while at the same time, the company’s payment terms to suppliers might be too short.
Some industries are known for having a highly negative OWC, and they are actually benefitting from it. Such an example is the fast-moving consumer goods (“FMCG”) sector. Their products are often sold from the shelves in cash before they actually pay their suppliers. Further, they can keep inventory low and might, due to their size, negotiate favorable payment terms with their suppliers.
What is the difference between basic shares outstanding and diluted shares outstanding?
Basic shares outstanding are the number of common shares held by all shareholders. Diluted shares outstanding further include the shares that would be held if all convertibles of that company were exercised and converted into shares. These convertibles include, amongst other things, options, warrants, capital notes and other convertibles.
What is a goodwill? What is a badwill?
Goodwill is the excess of a purchase price over the net fair value of the assets. The fair value of the net assets is the value of the assets in the books revalued at current market terms less acquired liabilities. Vice versa, if a purchase price is below the net fair value of the assets, a badwill (or negative goodwill) is created.
Conceptually, a goodwill is a form of intangible assets, such as a brand name and therefore located on the balance sheet. In some jurisdictions, the goodwill can be amortized over a certain amount of years and will hence reduce the taxable income through higher D&A, effectively increasing profits.
As an example, if the purchase price of a company is €100 with the company having fair value assets of €140 and liabilities of €60, the goodwill would amount to the purchase price less net fair value of assets, i.e. €100 – (€140-€60) = €20.
What is the difference between depreciation and amortization?
Depreciation is an accounting method that allows to write-off tangible assets over their useful life. Tangible assets are, amongst others, property, equipment, vehicles and computer.
Amortization is very similar to depreciation. It is, however, not the write-off on tangible assets but intangible assets. Those are, e.g., trademarks, patents, and copyrights.
The underlying principle behind depreciation and amortization is that assets lose value over time. This reduction of value should be accounted for on the balance sheet as well as the income statement. Not, however, on the cash flow statement, as no cash is involved.
What are the benefits of an income statement?
- The income statement provides an overview of the magnitude and development of revenues
- It allows for the composition and origin of revenues (e.g. by product or country)
- The income statement tracks the performance of the business
- It allows investors to see how much money is distributable to shareholders in the form of dividends
- The income statement gives a first glimpse on how the company might perform in the future
- It allows for the calculation of EBITDA and EBIT, which are used in financial modeling to value a company
What is the difference between net income and cash flow?
Net income measures the profitability of a company and can be found as the last item on the income statement. Although it tracks the profitability, it does not show how much of that profit converts into cash. This is where the cash flow statement comes into play.
The cash flow differs in a way that it shows the cash-ins and cash-outs of a company. A business could be profitable in a certain period but not generating a positive net-cash. Vice versa, it could also incur a loss on the income statement but generate a positive cash flow.
Investors might find cash flow more helpful to assess an opportunity since cash is what repays the purchase price or enables dividend payments.
If you had to choose from two of the three main financial statements, which ones would it be, and why?
This is a trick question. To most of the investors, the cash flow statement is the most important statement, since it shows how much cash a company generated. However, as a cash flow statement can be created using an income statement and two years of a balance sheet, it would be smart to choose those two and prepare the cash flow statement by yourself.
What are current and non-current assets? Can you name a few examples?
Simply put, current assets are all assets which lives are estimated not to exceed 12 months. These could be cash (which is not limited in its useful life), items held for trading purposes, accounts receivables or inventory.
An asset classifies as non-current if it has a use to the company of more than 12 months. These can be long-term financial investments, PP&E, and intangible assets.
Why does a balance sheet always balance?
This is due to the double-entry accounting system. All accounting transactions must be recorded in two different accounts. While assets show what the company owns, the liabilities and equity provide an overview of how the assets are financed (debt or equity).
Example 1: If you buy a machine using cash, your cash position goes down, while your PP&E goes up à net effect of 0
Example 2: If you buy a machine using debt, PP&E goes up, while a debt position in the liabilities section increases. à the total assets increase by the same amount as the total liabilities and equity
What is the reason that long-term debt can sometimes be found within the current debt section of the balance sheet?
Current debt includes debt items that have a life of no more than 12 months. If the long-term debt is maturing within the next twelve months, it is often labeled as “current portion of long-term debt” on the balance sheet.
What are the advantages of a cash flow statement?
- Informing on a company’s solvency and liquidity
- Eliminating the impacts of different accounting procedures of companies
- Providing information on a company’s various investing and financing activities
- Helping investors assess whether the company is able to generate future positive cash flows
- Providing support in evaluation changes in equity, liabilities and assets
- Giving explanations as to why and how income and cash inflow differ
Can the total change of cash on the cash flow statement turn negative?
There are a couple of ways this can happen. Not every time a cash flow statement has a negative bottom line, this should be seen as critical, though.
Example 1: The first line on the cash flow statement could already be negative, i.e. the company has generated a net loss for the period. The subsequent cash adjustments are not material enough to get the cash flow back into the black figures.
Example 2: The company made numerous investments in PP&E or acquired a large competitor. The subsequently negative cash flow from investing activities pulls the overall change of cash into the red figures.
Example 3: The company repaid large amounts of debt at the same time, using not only the cash generated from the current period but also the remaining cash from the balance sheet.
Example 4: The company bought back a large number of its own shares from the public. This example would be of great advantage for investors, as their earnings per share increases.
How do the three financial statements link together?
[to come soon]
What happens to the three financial statements if inventory increases by 100?
There are two options:
1. The inventory was paid using cash
2. The inventory was bought on credit
What happens to the three financial statements if accounts receivable increases by 100? Assume a 30% tax rate
What happens to the three financial statements if accounts receivable decreases by 100?
What happens to the three financial statements if depreciation (cost) increases by 100? Assume a 30% tax rate
We are in the business of selling orange juice. On day 1 we are buying oranges worth 100 on credit. On day 2 we are selling the freshly pressed orange juice for 150 against cash, and on day 3 we are paying the supplier. What happens to the three financial statements on each day? Assume 30% tax