Financial Modeling Test – Questions & Answers
We have compiled a list of the top 20 frequently asked questions in financial modeling that you must know if you plan a career in this field. This test will help you acquire a basic understanding of what financial modeling is all about, and you can also use this understanding to present yourself in interviews.
Please have a look at some of the test questions along with their answers that could help you get a deep insight into financial modeling.
Question #1 – What Do You Mean by Financing Modeling?
Answer: Financial modelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact. means building tools based on Excel spreadsheets to help a business forecast its future performance and earnings based on specific forecasting theories. This allows the management to make important financial decisions for the company.
Question #2 – What Are the Steps Involved in Financial Modeling?
Answer: You can follow the steps below to create a financial model –
- Gather historical financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc. for the last three to five years.
- Analyze historical information and assumptions to forecast future results and performance.
- The assumptions made are used to develop the three projected financial statements, namely income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., and cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business..
- Estimate the net present valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. of the future cash flows using the discounting technique. After that, do the sensitivity analysis to test the changes on account of key variables.
- Finally, conduct an audit and stress testing to check the model’s efficiency.
Question #3 – Give Any Four Examples of Financial Modeling?
Answer: Three statement modelThree Statement ModelA 3 statement model is a type of financial modeling that connects three key financial statements: income statements, balance sheets, and cash flow statements. It prepares a dynamically linked single economic model used as the base of complex financial models like leverage buyout, discounted cash flow, merger models, and other financial models., discounted cash flow model, merger model, and budgeting & forecasting model are a few examples of financial modeling.
Question #4 – What Are Some Uses of Financial Modeling?
Answer: Financial modeling is useful in the following domains:
- Deciding the source of finance
- Merger and acquisitionMerger And AcquisitionMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion. deals
- Budgeting and forecasting
- Cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc.
- Analysing the company’s stock performance
Question #5 – What Is Meant by Working Capital and How Can It Be Forecasted?
Answer: Working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" refers to the net funds available with a company for its day-to-day business activities; the same is derived after deducting current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. from the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. of the company.
Working capital = Current assets – Current liabilities
Question #6 – Which Are the Three Main Components of Financial Statements?
Answer: The balance sheet, income statement, and cash flow statement represent the three main components of financial statements.
Question #7 – What Does the Balance Sheet, Income Statement, and Cash Flow of Any Entity Indicate?
- Balance Sheet: It represents the financial position of a business entity at a particular point in time by reflecting the values of assets, liabilities, and equity.
- Income Statement: It indicates the financial results a business achieves through its activities in a particular period. The net profits are indicated by reducing the value of expenses from income.
- Cash Flow Statement: It provides information regarding the sources and application of funds through operating, investing, and financing activities.
Question #8 – What Is DCF Analysis?
Answer: DCF analysisDCF AnalysisDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance., also known as discounted cash flow analysis, is a type of valuation method that identifies the value of a business by estimating its future net cash flows and discounting them using an appropriate discount rate to its present value.
Question #9 – What Is Meant by Sensitivity Analysis?
Answer: Sensitivity analysisSensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions. is a tool of financial modelingTool Of Financial ModelingFinancial modeling tools are the set of information or skills or any other factor elements that helps an analyst evaluate the value of a company, a business segment or a project's viability. that helps an analyst determine how the values of certain dependent variables react to the changes in the values of certain independent variablesIndependent VariablesIndependent variable is an object or a time period or a input value, changes to which are used to assess the impact on an output value (i.e. the end objective) that is measured in mathematical or statistical or financial modeling.. For example, an analyst may determine how much profits are expected to reduce due to an increase in the rates of direct materialDirect MaterialDirect materials are raw materials that are directly used in the manufacturing process of a company's goods and/or services and are an essential component of the finished goods manufactured..
Question #10 – What Do You Mean by Financial Forecasting?
Answer: Financial ForecastingFinancial ForecastingFinancial Forecasting is the process of predicting or estimating future stats of an organization i.e. how business will perform in the future based on historical data like by analyzing the income statement, position statement, current conditions, past trends of the financial, future internal and external environment which is usually undertaken with the objective of preparing and developing budget and allocating available resources to ensure best possible utilization. refers to the identification of the estimated future performance of a business based on historical data available regarding the business.
Question #11 – How Can Revenues Be Forecasted?
Answer: There can be different ways to construct a forecasted revenue model. Some of them include:
- Sales growth
- Volume mix
- Change in prices
- Market size and growth
- Capacity utilization
- Product pricing, etc.
Question #12 – What Are Some Ways to Forecast Costs and Expenses?
Answer: Cost and expenses can be forecasted based on the following factors:
- As a percentage of sales
- All costs except depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. as a percentage of sales and depreciation as a separate item.
- Variable costs are based on sales, fixed costs based on historical trends, and depreciation as separate items.
Question #13 – Where shall a Company’s Historical Data Be Obtained?
Answer: The past financial data of any company shall be taken from reliable sources such as annual reportsAnnual ReportsAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements. or regulatory statements filed with SEC. Any other source may not be reliable.
Question #14 – Give a Few Examples of Financial Forecasting Methods.
Answer: Some examples of financial forecasting methods include the straight-line method, moving averageMoving AverageMoving Average (MA), commonly used in capital markets, can be defined as a succession of mean that is derived from a successive period of numbers or values and the same would be calculated continually as the new data is available. This can be lagging or trend-following indicator as this would be based on previous numbers. method, simple linear regressionLinear RegressionLinear Regression is a statistical excel tool that is used as a predictive analysis model to examine the relationship between two sets of data. Using this analysis, we can estimate the relationship between dependent and independent variables., and multiple linear regression.
Question #15 – How Financial Modelling and Financial Forecasting Differ?
Answer: Financial modeling involves developing financial analysis toolsFinancial Analysis ToolsFinancial analysis tools are different ways or methods of evaluating and interpreting a company’s financial statements for various purposes like planning, investment and performance. to estimate the financial performance of an entity in the future. At the same time, forecasting refers to determining projected cash flows and results using different techniques on the historical data of a company’s performance.
Question #16 – List Down the Financial Model Layouts.
Answer: There are two layouts, namely:
- The vertical financial model layout
- The horizontal financial model layout
Question #17 – What are Some Financial Ratios that are Used in Financial Analysis?
Answer: The common financial ratios that are used in the financial analysis include:
- Liquidity ratios such as current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities , quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities., etc.
- Return on assetsReturn On AssetsReturn on assets (ROA) is the ratio between net income, representing the amount of financial and operational income a company has, and total average assets. The arithmetic average of total assets a company holds analyses how much returns a company is producing on the total investment made.
- Return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.
- Debt to equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level.
- Gross profit ratioGross Profit RatioThe gross profit ratio evaluates the proportion of the direct profit a company generates from its net sales. Here, the gross profit is the returns acquired after considering the cost of goods sold, trade discounts and sales returns for deduction from the total revenue., net profit ratio
- Turnover ratiosTurnover RatiosTurnover Ratios are the efficiency ratios that measure how a business optimally utilizes its assets to generate sales from them. You can determine its formula as per the Turnover type, i.e., Inventory Turnover, Receivables Turnover, Capital Employed Turnover, Working Capital Turnover, Asset Turnover, & Accounts Payable Turnover. like inventory turnover ratioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.
Question #18 – What Do You Understand from Net Present Value?
Answer: Net present value refers to the present value of the future net cash outflows, i.e., the present value of future cash inflows reduced by the value of future cash outflows. The present valuesPresent ValuesPresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. are calculated using an appropriate discounting rate such as IRRIRRInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected..
Question #19 – What Is the Meaning and Use of IRR?
Answer: IRR refers to the discount rate at which the net present value is zero. It helps in making investment-related decisions as to whether a particular project is worth investing in or not.
Question #20 – Which Tools can be Used for Auditing the Financial Models in Excel?
- Model structure
- Go to special
- Trace precedents & dependents
This has been a guide to Financial Modeling Test. You can check your knowledge in financial modeling with these top 20 questions in less than 10 minutes. You can learn more about it from the following articles –