Case interviews: what finance concepts do I need to know?
Consultants use a wide range of financial concepts on their projects. Case interviews reflect real-life examples and you will therefore come across financial concepts when you interview. These concepts range from fairly basic (E.g.: fixed costs) to more advanced (E.g.: return on investment).
The difficulty is that there is an endless list of financial concepts you could learn. But you do not have time to learn and master all of them and doing so should not be the objective of your preparation.
When you prepare for case interviews , you therefore need to ask yourself the following key question: What are the financial concepts I need to master to ace case interviews?
The answer depends on the position you are applying for. In this blog post, we assume that you are interviewing for a general consultant, associate or manager role at a typical strategy firm (E.g.: McKinsey, BCG, Bain, etc). If you apply specifically to the financial services practice of the firms above, you will need to know more advanced financial concepts than we list below. But for general positions, here is the list of financial concepts you need to master:
- Fixed and variable costs
- Return on investment
- Payback period
There is a very small chance that you might come across more exotic financial concepts in your case interviews. But in these cases you will not be expected to know the concept at hand. Instead, your interviewer will expect you to ask clarifying questions about the concept and will help you understand it.
There are three reasons why you do not need to know more financial concepts than the ones listed above:
- First, in our experience, these concepts will enable you to tackle 99% of the cases you will come across in your interviews
- Second, learning more concepts than this would be very time consuming. Instead you should use your time practicing on real case interviews
- Third, consultants themselves usually do not know more financial concepts than the ones we have listed. As a consequence if a more advanced concept is required for your case it is almost certain that your interviewer will help you understand it
Let us now define the concepts you need to know one by one.
We’ve already defined basic financial concepts in our McKinsey PST Essential Business Knowledge blog post as well as in the video below. The first three bullet points below are reproduced from that article. The next two are additions.
Revenues, sales, or turnover (the three terms are synonyms) are the total amount of money that the company receives from customers by selling its products.
Let’s take an example. Imagine you work for an airline, such as British Airways. You sell plane tickets to your customers. The total amount of money you collect from customers in exchange for plane tickets (and any additional services you provide) is your company’s revenues.
There are two main ways you could be asked to calculate revenues for a company:
You might be given the number of products the company sold (the volume) and the average price of the products. From this, you can obtain revenues using the following formula: Revenues = Volume x Average Price.
Alternatively, you could be given the total sales in an industry (total market sales), and the share of the industry’s revenues represented by the company (the market share). The company’s sales would then be given by: Revenues = Total Market Sales x Market Share.
Either way, remember that revenues or sales are measured in terms of money (Dollar, Pound Sterling, Euro, etc.).
Costs, or expenses, are the total amount of money that the company pays to its various suppliers. In the case of the airline above, this will be the money that the company pays for fuel, leasing airplanes, the salaries of the crew, as well as expenses such as the cost of running their headquarters, their website, or even taxes and interest on loans.
As you can see, the term ‘costs’ covers many different items. Companies will be interested in tracking costs closely.
Fixed and variable costs: Businesses incur two types of costs. Variable costs are the costs that increase with higher sales or higher production. Fixed costs are the costs that would have to be paid regardless of how much is produced. In other words, variable costs change with the level of business activity, while fixed costs don’t.
Let’s imagine you are the CEO of a handbag manufacturer. The cost of the material you use to manufacture the bags is a variable cost: the more bags you produce, the more leather you will need. If one day you produce no handbag, then you don’t have to pay for any extra material. By contrast, the rent you pay for the store has to be paid every month, regardless of whether you sell or produce any bags that month.
As you may already appreciate, the distinction between fixed and variable costs is not always straightforward. For instance, labour costs can be either fixed or variable. As a CEO, your salary is a fixed cost as it will be paid independently of how many bags the company produces. However, during periods of peak production you might hire extra workers at your factory and their salary will therefore be a variable cost.
Even though these difficulties might arise, your interviewer will always allow you to determine easily from the context which cost is fixed and which is variable.
The most important relationship in business analysis is probably the following:
Profits = Revenues – Costs
Profits, also known as net income or net earnings, represents the money left to the owners or managers of the business after all expenses have been paid. Many questions in case interviews revolve around whether or not a company is profitable and what it should do to become more profitable.
Profits are always calculated over a certain period of time – either a quarter or a full year. If you are given fixed and variable costs, you would first have to calculate total costs over the period of time studied, before being able to calculate profits. For instance, in our handbag manufacturing example you would take all fixed costs for one year and add all variable costs for the production of that year to calculate total costs. Annual profits would then be given by subtracting total costs from annual revenues.
Given this definition of profits, there are two ways companies can increase their profits: increase revenues, or decrease costs. You can also see why it might not always be completely straightforward to compare the performance of two companies: one might have higher revenues but higher costs than the other.
4. Return on investment
Return on investment (ROI), or return on capital invested (ROCI), measures how much profits are generated by $100 invested in a given project or business. Let’s say you set up a lemonade stand with an initial investment of $1,000 to pay for a stand, a lemon press, etc. Let’s now assume that you sell $500 worth of lemonade throughout the year and that you incurred $400 in costs to make those sales (E.g.: lemons, sugar, electricity, etc). Your profit for the year is $100 and your return on investment is $100 / $1,000 = 10%.
The formula for return on investment is therefore given by:
Return on investment = Profits over given period / Initial investment
Returns on investment are expressed in percentages and calculated over a given period of time, usually one year. But nothing prevents you from calculating a daily or monthly return on investment. To do so, you just need to divide a day’s worth of profits or a month’s worth of profits by the initial investment. For a given project, profits made in a day are lower than profits made in a month or year, and the daily return on investment is therefore lower. In our example, assuming we make $100 / 365 = $0.27 of profits in a day, the daily return on investment is $0.27 / $1,000 = 0.027% which is lower than 10%.
Let’s focus on the initial investment part of the equation. In your case interviews, you will most likely have to calculate ROIs when a company is investing in a new project. Here, the initial investment will be the upfront expenses the company needs to make to start the business. For instance, if the company wants to start producing cars, building the car factory will be the main initial investment. Similarly, if the company wants to start a supermarket, the main initial investment will be the building, fridges and shelves to set up the supermarket (assuming it buys the building). Initial investments are typically only incurred once, at the beginning of the project.
Finally, there are two ways to increase ROIs: growing profits or decreasing the initial investment. Sometimes, the return on investment for a project will be negative. This indicates that profits are negative and that the project is losing money.
5. Payback period
Payback period measures how much time it takes to earn back your initial investment. In our lemonade stand example, it takes 10 years of profits at $100 per year to pay back the initial investment of $1,000. The payback period is 10 years.
The formula for payback period is therefore given by:
Payback period = Initial investment / Profits over a given period
Payback periods are usually expressed in years by dividing the initial investment by the profits per year. But notice that they can also be expressed in days or months too simply by dividing the initial investment by the profits per day or the profits per month.
Finally, notice that the payback period is simply the inverse of the return on investment. In our lemonade stand example, the yearly return on investment was 10%. To calculate the payback period we could have simply done 1 / 10% = 10 years. Again, in some cases the payback period will be negative which indicates negative profits and that the project is losing money.