We have been conducting a lot of mock interviews for investment banking over the last few weeks pro bono. We love educating students and aspiring bankers, but quality and preparation have been absent, so it has become a job and we may have to start charging money.
One of the technical questions that candidates will always get is “Walk me through a DCF”. The other one which almost always gets asked, but is sometimes omitted because it is so basic is some variant of “How does $10 of depreciation flow through the three statements?”
It is because everyone with a finance degree is supposed to know how basic entries flow through the three statements that these questions are only pulled out when the candidate’s resume is suspect – usually a varsity athlete from a brand name school with a missing GPA or a liberal arts major who snuck into the pile because of a referral.
Lamentably, both aspiring bankers and actual bankers looking to move to another firm/private equity have failed this question.
These are the most common pitfalls:
Starting with the Balance Sheet
Start with the income statement and have it flow through to cash. This is the easiest way to capture the ramifications of tax, which will change the final numbers on the balance sheet.
Balance Sheet Does Not Balance
If Assets do not match Liabilities plus Equity the answer is wrong.
Not Knowing Which Way Working Capital Changes Go
If accounts receivable or inventory goes up that means cash went down via the indirect method.
Taking Too Long
This question ideally takes 30-45 seconds, and maybe a minute if there are a lot of esoteric variables (PIK interest, etc.). I usually stop paying attention after 1 minute and cut people off after 2 minutes.
Example Three Statement Walkthrough
We are going to run through a busier example to highlight all the things that a candidate should consider. We will post one to do with working capital next time.
- A company buys a factory for $200 financed with 50% equity and 50% debt. Of this 50% debt, the interest rate is 10% and half of it is payment-in-kind (PIK), which means that interest is paid out in the form of more debt. Walk me through year one for the three statements and is there any other information that is required?
Follow Up Questions
The candidate should inquire about the depreciation schedule. Let us assume it is straight line with a useful life of 10 years and no salvage value.
The candidate should also inquire about the tax rate. Let us assume it is 40%.
The candidate should also ask if the debt is amortizing or bullet. For this example, let us assume it is a bullet payment.
Depreciation of $20 is an income statement item.
Depreciation +$20, so EBIT is -$20.
Interest is 0.5*200*0.1 = $10.
As such, EBT is -$30.
The company will accordingly pay 30*0.4 or $12 less in tax.
The change to net income is -$18.
Cash Flow Statement
Cash Flows from Operations (CFO)
Net income -$18
PIK Interest 10*0.5 = +$5
Cash Flows from Investing (CFI)
Purchase of Building -$200
Cash Flows from Financing (CFF)
Issuance of Debt +$100
Total Change to Cash = $7 – $200 + $100 = -$93
less: Accumulated Depreciation = -$20
Loan + $105 ($100 + $5 in PIK Interest)
Shareholders Equity -$18 (from the net income)
Liabilities + Equity +87
Excellent! Now to master these examples assume the debt amortizes over 5 years and the building blows up in year 3 and is impaired, and the loan is called and walk through year 3.