Trevor's Guide to Case Interviews for Finance and Consulting

This is the original version of Trevor's Guide to Case Interviews. Please do not print or copy-paste this information anywhere, including into email. You are welcome to link or bookmark the original page. Copyright 2009 to me, Trevor F. Updated 1/26/10.


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This is a guide to how to prepare for case interviews for Finance and Consulting.

FOUR KINDS OF QUESTIONS (Each firm prefers different types)
1. Logic / Arithmetic (usually, but not always, in finance)
“What’s 42 x 37?”
“You have a 5L jug and a 3L jug. Measure out 4L in as few steps as possible.”

2. Market Sizing
“How many lightbulbs were sold in Australia last year?” (Approximate)

3. Strategy (Consulting. Sometimes finance)
“You’ve been brought in to a small pharmaceutical company to help them assess whether to proceed with a drug development project. Ask any questions you like.”

4. Mathematics / Statistics (Quant)
“There’s a jar with 1000 coins. 999 have heads and tails. One has two heads. You pull out one coin randomly and flip it 10 times, getting 10 heads in a row. What is the probability you pulled out the coin with 2 heads?”
Usually not regular consulting or banking – usually a more quantitative job, i.e., hedge fund.

I will go through each of them, one at a time.


1. ARITHMETIC AND LOGIC
Can’t help you with this much.

If it helps you, break logic questions into math.

For straight arithmetic it can be helpful to split into 10’s and ones.

e.g. 42 x 37 = (40 + 2) x (30 + 7) = (40 x 20) + (2 x 30) + (7 x 40) + (2 x 7)

Relax, and take your time.

It’s better to get the right answer slowly than the wrong answer fast.



2. MARKET SIZING
Basically dimensional analysis (remember middle school science?)

Oranges consumed in Europe = Oranges consumed per person x people in Europe

Sprinklers sold in the US =

Sprinklers sold to golf courses + Sprinklers sold to professional gardening services + Sprinklers sold to individuals

It's easy to make this too complicated, and you can get bogged down.

Amount of gas consumed in the US =

(# PEOPLE x CARS/PERSON x MILES/CAR x GALLONS/MILE) + (GALLONS/MILE x MILES/FLIGHT x (CITIES IN US / 2) x FLIGHTS PER PAIR OF CITIES) + ((LAWNMOWERS/GOLF COURSE x GOLF COURSES IN US) + (LAWNMOWERS/PROFESSIONAL SERVICES x PROFESSIONAL SERVICES IN US)………


KEYS:
1. Break the Problem Down

Number of Beetles in the Congo -> ???
Beetles/Tree x Trees/Mile x Miles of Forest/Congo -> You can roughly estimate these

2. Orders of Magnitude, Not Real Numbers

1 million vs. 2 million doesn’t matter
1 million vs. 10 billion does

3. Simplify!

Define the scope of the problem, don’t tackle everything.
Gas in North America -> ???
Gas used in trucks in North America for shipping things -> EASIER


3. STRATEGY
Skip this for one second

4. MATH/STATISTICS
If you’re asked and have no idea, get a piece of paper + pen and slowly work through it logically.

If you get it wrong, don’t give up hope. If you were logical but just got stuck, or made an arithmetic error, it doesn’t rule you out.

Stay calm and confident. Take your time.

3. STRATEGY
To start: Ensure you are focusing on the correct question. The first key to this is listening to the interviewer. You can verify what you're working on by asking - "So, in summary, I'm looking at both the revenue and cost sides of operations for a hard drive manufacturer, and coming up with a plan for them to increase their profitability. Is that correct?"

Additionally, feel free to ask any followup questions. As long as it's not something stupid ("how would you do it?"), it can provide helpful information ("What sort of parts go into a hard drive?" would be one possibility, for example). If they don't want to tell you, they'll tell you.

Because these things are inherently logical, it will be useful for clarity and for ensuring that you hit everything for you to state the framework on which you're operating. So, if I were doing this (and you'll see this all below), I'd say "I'm going to first look at the industry, then I'm going to go down the income statement, starting with revenues, then variable costs, then fixed costs, and I'll conclude by going over to the balance sheet and looking at working capital". If industry analysis is relevant, I'd start with that. Having laid all of this out at the beginning, it'll help you pace yourself and stay on topic, and give them the chance to pace you and keep you on the right track.

So - onto the actual framework itself. I like using financial statements because businesses are measured with their financial statements. Working on things that affect financial statements is a guaranteed way to talk about things that matter. If done correctly, they also have the advantage of not being way overused, like Porter's Five Forces (mentioned below because its still useful, especially for entering new industries) or some other BCG and McKinsey strategies that I won't go into here.

2 Big Statements to Think About:
Income Statement
The set of revenues, profits and costs that came in and out in the period
Flow. It's the in- and outflows for the period

Balance Sheet
The set of assets and liabilities you have
Snapshot. It's the list of stuff you have at a given time.

An analogy is that the Income Statement is your salary, and the Balance Sheet is your bank account and mortgage.

Here is where blogger's formatting hurts, so I'll try to keep this simple.

SIMPLIFIED INCOME STATEMENT
REVENUES (Sales)
Price * Volume
(Price per chicken * Chickens you sold)

- COST OF GOODS SOLD
Variable costs (costs that fluctuate with the number of things you sell)
(Chickens * Chicken Feed/Chicken, Chickens * Hours of Labor/Chicken)

= GROSS PROFIT

- SG+A
Short for Sales, General and Administrative Costs
Fixed costs (costs that don't directly fluctuate with the number of things you sell)
(Chicken coop maintenance costs. CEO Salary. Salespeople salaries)

= OPERATING PROFIT

- Interest, Taxes, and other stuff you can safely ignore for interviews

= NET INCOME
Total Profit for the Company, to be split up among owners of the company


SIMPLIFIED BALANCE SHEET

Some definitions:

Assets: Stuff that will eventually result in money for you
Liabilities: Stuff that will result in you paying money
Equity: The residual value (Assets - Liabilities)
Money you get - Money you give = What it's worth

By definition, A - L = E.
This is usually written A = L + E, because it's easier to set up the balance sheet that way.

It is vitally important to note that this is recorded at original cost, and then lowered ("depreciated" or "amortized", depending on the asset) over time as it loses value. Thus, if I bought a building in 1920 for $300, it will be no more than $300 on the Balance Sheet.
Thus, equity on a balance sheet is only a rough estimate of the actual value. It's a better estimate of the money that has been put into the company to build it. Don't worry about this too much, but understand it.

Typical Balance Sheet:
Assets
Cash + Marketable Securities

Inventory

Receivables

Hard Assets (buildings,
vehicles, property, etc)

Acquired Intangible Assets
(patents, acquired brands,
customer lists, "goodwill",
etc. These can only be added
to a balance sheet when you
buy them, not when you
make them. This is because BS
measures what you've put into
the business, and if you make them,
they've already been reflected through
expenses that hit the equity account)

Liabilities

Payables

Debt
Other Stuff
Equity
Don't sweat the equity account too much - just know that profits get added here each year, and payouts (dividends and buybacks) get subtracted.
I don't know how to do it on Blogger, but this is typically arranged like you're looking at the pages of an open book. On the left page are assets, at the top of the right page are liabilities, and underneath liabilities are equity. (Thus, why A = L + E is the right format - it's all additive, you don't have to worry about which section to subtract, so the right page all added together equals the left page). Some companies do put them sequentially like I have, but that's beyond the scope of this presentation.

Cash: Cash. $ in the bank

Marketable Securities: Stocks, bonds, Bank CDs, etc, that can be easily sold

Inventory: The cost of making the goods you have to sell but haven't sold yet. Want this to be just high enough to sell what you need, and no higher

Receivables: What people owe you

Payables: What you owe people (think credit cards you pay at the end of the month)

"Goodwill": A measure of the additional amount you paid for an acquisition that isn't reflected in their other assets. Just remember - this is designed to measure how much has been put into the business, so paying up for "intangible awesomeness" counts.


EVERYTHING YOU SAY SHOULD IMPROVE ONE OF THESE:
1. Increase Revenues -> price per unit * units sold
2. Reduce Fixed Costs
3. Reduce Variable Costs
4. Balance Sheet Efficiency

Less inventory is good because there's less spoilage, and less money invested in stuff that
just sits there.

Less receivables per unit of revenue is good because you're getting your $ faster, and you
don't have to wait for it (and there's less risk they won't pay)

More payables per unit of COGS is usually good because you can wait longer til actually
paying and do something else productive with the money in the interim


FOCUS ON #1, then #3, then #2, then if you get it, #4. #4 is (usually) less important in interviews.



Three concepts you should know: EXPECTED VALUE, RETURN ON INVESTED CAPITAL and EARNINGS PER SHARE.

EXPECTED VALUE

The probability-weighted amount something is worth
EV(project) = (amount you make in scenario A x probability scenario A happens) +(amt you make in scenario B x probability scenario B happens)... across all scenarios

ex:
A pirate is deciding whether to hunt for buried treasure. If he finds it, he'll get 1000 doubloons. If he doesn't find it, he gets nothing. The expedition will cost 250 doubloons. The chance of finding treasure is 30%. Should he undertake the endeavor?

(1000-250)x(30%) + (0-250)x(70%) = 50.

The expected value of the search is 50, which is greater than 0. The expectation is that he makes money, so he should do it.

This concept is how casinos and lotteries make money... all of your bets are expected value negative for you and positive for the casino, even if some outcomes are positive for you and negative for the casino.


RETURN ON INVESTED CAPITAL
The amount of profit you make on money you invest.

Different to costs.

If I buy $10 of wood and make a chair out of it and sell it, the wood is gone and the money I put into buying it is gone - it's a COST.

If I spend $1000 on opening a store, or researching a patent, and then use that store or patent to sell things, I can sell and still own the store or the patent -
it's an INVESTMENT.

Individual projects have a return on invested capital (ROIC):

I open a store for $1000
I make $200 a year profit from the store
My ROIC is 200/1000 = 20%.

This works for expected values, too:
I open a store for $50
My expected value profit is $5 from the store
My expected value ROIC is 5/50 = 10%.

Putting it in context:
You want your ROIC to be more than the "cost of capital" - If you have to borrow money at 10% interest to invest in a project that returns 8%, you're losing money.

This is why it's such a bad idea to invest in the stock market when you have credit card debt - the amount you're paying by having credit card debt is so much higher than any reasonable stock market return, that your "cost of capital" exceeds your expected ROIC and it's a bad investment, even if your stocks go up.

Thus, profits going up is not necessarily a good thing if you could have done better things with that money.

Thus, be careful if you're presented with profits that quadruple! If it required a lot of capital to achieve, it's not that impressive.

What a "good" ROIC is depends on how risky the project is. If it's over 15% it's likely a good ROIC. If it's under 10% and it's risky, it's more likely to be bad. If it's truly risk-free, it can be a very low ROIC and still be ok.

Whole companies have ROICs, also. Their invested capital consists of equity and debt. (Think about it - if you're running a business and you need money, you can either borrow it - debt - or give someone a share of the profits in exchange for money - equity. Then, you pay off debtholders first, and whatever is left is divided between the equityholders. This is similar in concept but different in specifics to the equity on the balance sheet.)

Generally, average ROIC for whole companies is somewhere between 11 and 13%.

Investment = the equity capital and debt capital that went in
Return = net income out

ROIC = Net Income / (Debt + Equity)

Whole company ROIC is far more important for finance than consulting. Its use is nuanced, look it up if you're curious.




EARNINGS PER SHARE
One more note on equity as invested capital. If a company issues equity to raise capital (a cut of the future profits in exchange for money), the people who already owned equity lose money because they're now getting a smaller percentage of the profits. The "profits" attributable to each share is called earnings per share (EPS), and it can be calculated for public companies for a given year by Net Income / Shares Outstanding. You can actually have net income go up and EPS go down if shares outstanding rises too fast (and stock price is usually judged by EPS). These profits aren't all paid out immediately - some of them will be used by the company to grow. The part that is paid out is called a dividend. Some companies buy back shares instead of paying dividends to increase future EPS for the rest of their owners. This is mathematically identical to paying dividends, but they're taxed differently.


PORTER'S FIVE FORCES:
Everyone and their mother has a preferred way of analyzing firms and industries. While many of these are useful in other contexts, I think they have the ability to send you down irrelevant or less central paths in interviews. If you can remember everything and keep it straight, that's great, but if you're time-constrained, some of them are more useful than others. One of the best, because its founded in actual economic principle, is Porter's Five Forces. It's particularly useful for analyzing the ongoing competitive strength of a company or industry, which is really nice when you're looking at questions like "Should I enter this industry?" or "Should I develop this new product?/What product should I develop?". (Michael Porter is a very famous HBS professor).

According to Porter, the strength of a company in general can be measured with five large assessments:

1. Threat of substitution. How easy would it be for customers to switch to other products or services instead of buying yours? This can be affected by many things - brand loyalty and product differentiation, importance of the product, advantage of the product over competitors' products, relative prices, switching costs, quality, etc.

2. Barriers to entry. If the market is profitable, others will want to participate, increasing competition and decreasing profitability. How easy is this? Think of patents, contracts, brand, economies of scale, switching or sunk costs, capital requirements, learning curves in manufacturing, government policy, industry profitability, distribution, etc.

3. Competition by incumbents. Innovation, advertising and product differentiation are important here. This is also where things like collusion, cooperation, price wars, etc. come in.

4. Customer power. How much can customers dictate your prices and your product features? If a customer has a lot of power, they can force you to spend more on your product and take less money for it. Anyone who sells to Wal-Mart or the Department of Defense would face this. Indications of customer power include number and size of important customers, fixed/sunk vs variable cost balance (customers can be forced to pay variable cost but not fixed or sunk costs), relative switching costs (Wal-Mart can switch easily, you can't), substitute products or distribution mechanisms on either side, buyer price sensitivity, product differentiation.

5. Supplier power. Similar to customer power, but instead, it's the people you're buying from, not selling to. Same considerations apply.

Economics - You can probably skip this if you're really pressed for time and understand extremely basic supply and demand, but this can be very useful.
Supply and demand are extremely important. Generally, as supply goes up, quantity supplied goes up and price goes down. As demand goes up, quantity supplied goes up and price goes up.

 For example, if you're buying wheat, then if twice the number of people show up to your same farm to buy wheat than did yesterday, the price is going to go up because demand has increased - the demand curve has shifted. However, if the same number of people as yesterday come back tomorrow, then the price will revert to its original level - you're moving along a stable supply curve with a shifting demand curve.

If, however, there is so much rain this summer that supplying the same amount of grain costs far less, then the supply curve has shifted, so more people show up and pay less for their grain.

The percentage by which quantity changes relative to the percentage by which price changes is called elasticity. There's a price elasticity of demand and a price elasticity of supply.

Examples of elasticity:
elastic supply: High tech (expensive) deep sea oil wells.  If price a supplier can get for their good drops even a little bit, they produce a lot less cuz its no longer profitable.
inelastic supply: Software or Movies. Once you've put in the development cost, the marginal cost is almost nothing, so price can drop a TON and the company will still be willing to sell lots of copies.
elastic demand: Newspapers in 2010, Cars, TV dinners, books, beef, many commodities. As price goes up even a little bit, they become a lot less attractive relative to alternatives, so you consume a lot less.
inelastic demand: Medical care, cigarettes, newspapers in 1950. Price can go up a ton and everyone will still buy.

 If you want to know more, take an intro economics class, or read the rest of my blog at http://www.econthoughts.com/, because elasticity something I talk about with reasonable frequency (esp vis a vis China, housing, and sometimes healthcare or carbon emissions).


Be able to draw a supply and demand graph. Supply goes up, and demand goes down, with quantity on the x axis and price on the y axis.

Also be able to "think on the margin". The price of a good isn't set by what everyone is willing to pay for it, it's set by what an incremental customer is willing to pay for it. In fact, most decisions need to think "on the margin". Think of it this way:

You have no job and have so much free time that you're bored. Someone offers you work for an hour a day at $7 an hour. Should you take it?

You have a job for 7 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

You have a job for 14 hours a day at $7 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

You have a job for 14 hours a day at $25 an hour. Someone offers you an additional hour of work per day at $7 an hour. Should you take it?

The answer to all of these questions is very different, because you don't look at the value of your time on average, you need to think "what is the value of one ADDITIONAL hour of work vs free time for me, given the amount of time I work and the amount of money I have?"

This also goes for goods. If you are in the desert with no water, how much would you pay for a cup of water? If you are in your living room with a case of water that you could open now or later, how much would you pay for a cup of water? If you were drowning in the Poland Springs bottling plant, how much would you pay for a cup of water?

Again, water doesn't have an inherent value - its value is how much you'd pay for one more of it (which would certainly be positive and large in the first case, positive and small in the second case, and negative and large in the last case).

An example of where this is important is tax policy. If you tax corporate profits if the supply curve has a positive slope (like most normal ones do after a point), then producing that last widget isn't worth it, so the company makes less widgets. If you tax income, then working that last hour isn't worth it, so the worker works fewer hours.

This also applies to cost shocks - if your input costs go up and you can't raise prices, then you'll produce less because that last unit you're making is no longer profitable.




Practice:

You've been brought in to advise a local clothing store on how to grow profits. It's a high-end women's fancy clothing maker, and they currently have 5 stores in NYC, Boston, LA and Chicago.

Think of:

What are the company's sources of revenue?

What are trends in these revenue sources?

What are the variable costs associated with the revenue?

What are the fixed costs associated with the revenue?

Trends in variable costs (material):

Trends in fixed costs (storefronts):

Competitors and how strong they are/how you can beat them (price? product differentiation?)

Substitutes for the company's product/how you can beat them (price? product differentiation?)


Then create:
Some suggestions to boost revenue (not right or wrong, just some ideas)
advertising
expanding to high-end men's goods
opening new stores
expanding existing stores
improving store locations - where should they be?
opening a partner brand for lower-end clothing
loyalty program
Some suggestions to lower variable costs:
Install a better inventory system so it takes salespeople less time to sell
Some suggestions to lower fixed costs:
Geographically consolidate
Improve distribution centers
Finding cheaper, "nichey" store locations
Some suggestions for balance sheet efficiency:
Install an inventory-tracking system (could be a loyalty program) so you can reduce inventory w/o affecting sales
this reduces a) inventory hours by salespeople
b) the amount of money you have tied up in clothes sitting in a backroom - the $ can be used elsewhere!
as a note, Wal-Mart is a GENIUS at this, and it's one major reason they've succeeded

Others:

You've been brought in by a company that makes airplanes to help them cut costs. Where would you look?

You've been brought in by a pharmaceutical company to evaluate whether the company should try and develop a cure for ingrown toenails. Create a framework to help them make this decision.

You've been brought in by a movie theater to help boost overall profits. How would you approach the problem?

A tractor-maker has invented a technology that lets their tractors hover. They don't know what to do with it. Help them figure out how to offer it to the marketplace.

Your client needs help deciding whether to buy a chain of upscale, trendy grocery stores (think Whole Foods) that's been struggling lately. What can they do to turn it around, and how should they decide whether to buy?



Other Recommended Reading:
Case in Point (check it out on Amazon)
summarized here: http://consulting.caltech.edu/cit-only/case_in_point.ppt