Students often begin their study of financial modeling by diving into the underlying financial theory. This is a sensible place to begin. For example, one may choose to pursue an economics or business degree, or perhaps self-study with resources such as Investopedia or Rosenbaum and Pearl’s Investment Banking textbook. Yet, at what point do you know enough financial theory to begin building practical financial models?
Theoretical understanding does not guarantee practical acumen
Too often, I have interviewed candidates with a firm grasp on the theory who stumble when asked simple modeling and valuation questions to test their practical knowledge. The mistake is to study only financial theory without considering its practical applications in Investment Banking and Private Equity.
Up to a point, understanding financial theory helps one build better financial models. Yet after a point, financial theory begins to delve into nuanced subjects that are not directly relevant to the daily routines of Investment Banking and Private Equity professionals. Eventually, one must progress from studying financial theory to practically applying it within financial models.
So at what level of theoretical comprehension should one consider oneself prepared to progress from theory to practical financial modeling?
How much theory do you need before you should begin building practical financial models?
In my opinion, you should focus only on studying financial theory until you grasp two fundamental concepts. First, you must familiarize yourself with the time value of money. Second, you must understand the fundamentals of capital structure as it applies to seniority and residual ownership.
Questions to Test your Theoretical Knowledge
If you can answer each of the following questions with certainty, I believe you know enough to begin building financial models:
Time Value of Money
- Briefly describe the time value of money.
- What purpose does the discount rate serve in financial analysis?
- What factors could increase or decrease a discount rate?
- How would an increased discount rate impact the present value of a DCF?
- Below what discount rate would you prefer to receive $1,000,000 in 2 years as opposed to $850,000 today?
Capital Structure
- Who gets paid first at sale: the bondholders or the equity holders?
- What distinguishes levered cash flows from unlevered cash flows?
- What is the enterprise value of a corporation that has issued $10B of debt, holds $1B of cash on its balance sheet, and whose 10,000,000 outstanding total diluted shares are each valued at $1,000 per share? What is its gross leverage? What is its net leverage?
- At the very start of the year, you purchase an apartment building at 75% LTV with $40M of your own money as equity. Imagine you sell this apartment building for $165M total. Focusing only on the asset appreciation, what is the unlevered ROI in this investment? What is the levered ROE?
If you can answer each question above, you know enough theory to begin financial modeling
If you clearly understand the responses to each of the questions above, congratulations. You understand enough theory to begin building practical financial models. At this point, you should divide your studies between theory and practice. In fact, I would suggest a 25/75 split between theory and practical financial modeling.
The only way to truly learn financial modeling
The only way you will learn financial modeling is by getting your reps in. Like any form of exercise, mental training requires consistent repetition in order to progress. Remember, IB and PE professionals build financial models every day. If you want to stand firm in an interview, you should build at least one financial model per week.
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