Introduction
A modeling test looks like a test of spreadsheet skill, and speed does matter. But the errors that most often sink a model are rarely formula errors. They are balance sheets that do not balance, cash that appears from nowhere, debt that is repaid without reducing cash and taxes calculated on the wrong line. Those are accounting errors, and under time pressure they are the ones that decide the result.
The reason is that a financial model is the three statements projected forward, with every link the candidate would describe in an interview now built explicitly. A candidate who understands how the statements connect can build a model that balances at the first attempt and find the error quickly when it does not. One who knows the links only as a spoken answer often cannot, because a spoken answer never has to make the balance sheet tie at the end.
The Formats and Where Accounting Sits
Modeling tests come in a few common forms, and accounting matters in each. A paper leveraged buyout (LBO), done with pen and paper in a few minutes, tests whether a candidate can move from purchase price to returns using simple accounting: earnings before interest, taxes, depreciation and amortization (EBITDA), interest, taxes, debt paydown and exit value. The accounting is simplified but must be right: taxes are charged on EBITDA less depreciation, amortization and interest, not on EBITDA, and the cash available to repay debt is net income plus those non-cash charges less capital expenditure and any increase in working capital. The blog's guide to doing a paper LBO in five minutes covers the format.
Timed tests, typically one to three hours, ask for a three-statement model, a merger model or an LBO built from a short case description. These are the tests where accounting failures are most common, because every link has to be built and there is little time to debug. Take-home case studies, given over several days, add interpretation and an investment recommendation, but they rest on the same mechanics. Lateral candidates and those recruiting for private equity meet these most often, as described in how accounting is tested in banking interviews.
Linking the Statements Correctly
A model that balances is built in a linking order that mirrors the accounting. Forecast the income statement first, from revenue down to net income. Project the balance sheet items that drive cash flow from their own assumptions: working capital, property, plant and equipment (PP&E) through capital expenditure and depreciation, and debt through its repayment schedule. Build the cash flow statement from net income and the changes in those items. Then let cash on the balance sheet come only from the cash flow statement.
The Rules That Keep a Model Whole
Three rules prevent most errors. First, every change in a balance sheet line other than cash must appear on the cash flow statement, either as a cash flow or as a non-cash adjustment such as the depreciation add-back; the only exception is a non-cash exchange between two balance sheet lines, such as debt converted into equity, where the two changes offset. Second, cash is never forecast directly; it is always the prior balance plus the net change in cash from the cash flow statement. Third, every major balance is rolled forward from its opening amount:
- Roll-forward
A schedule that moves a balance from its opening to its closing amount through the flows that change it, such as opening PP&E plus capital expenditure less depreciation equals closing PP&E. Building each major balance this way ensures that every change has a matching entry on another statement.
The core roll-forwards in most tests are PP&E, debt and retained earnings, which grows by net income and falls by dividends, as described in PP&E and debt roll-forwards and the retained earnings roll-forward. When the closing balances on the balance sheet are linked to these schedules, and the flows in the schedules are linked to the income and cash flow statements, the model has nowhere to leak.
Fixing a Balance Sheet That Does Not Balance
Even careful candidates sometimes see a balance check that is not zero. The worst response is to search randomly, or to plug the difference. The best is to use the size and pattern of the gap as evidence, because they usually point straight at the error:
| What the gap looks like | Likely cause |
|---|---|
| Equal to one line item in one period | That item is missing from the cash flow statement or the balance sheet |
| Equal to twice a line item | The item has the wrong sign in one place |
| Starts in the first forecast period and stays constant | An opening balance or a one-time item, such as a fee, is misstated |
| Grows every period | A recurring flow, such as depreciation or a working capital change, is mislinked |
| Appears only after a transaction | The sources and uses or purchase accounting does not tie |
Start with the first period that fails, since later periods only compound the error, and compare the gap with the flows in that period.
The usual suspects are items that touch the balance sheet without passing through the obvious lines: dividends, which reduce retained earnings and cash in financing; stock-based compensation, which is added back and increases equity; deferred taxes, which change a deferred tax liability or asset and appear as a non-cash adjustment; and amortization of financing fees, which is non-cash interest. Checking these first saves time, and the logic behind the check is set out in the balance check.
Accounting Judgments Inside the Test
Beyond linking, tests contain accounting choices that graders notice. Interest is the most common: calculating it on average debt balances is more accurate but creates a circular reference, because interest affects cash flow, which affects debt repayment, which affects interest. Many tests specify interest on opening balances to avoid the problem; if they do not, state the choice. Taxes should be calculated on pre-tax income after interest, and a loss year needs deliberate handling: it pays no cash tax, and the net operating loss (NOL) it creates carries forward to reduce taxable income in later years under Internal Revenue Code section 172. A model that simply multiplies the loss by the tax rate shows the government paying the company cash.
Working Capital and Minimum Cash
Working capital is usually forecast from days or percentages of revenue and cost of sales, and the sign convention is where errors start: an increase in receivables or inventory is a use of cash, an increase in payables a source, as explained in working capital drivers: DSO, DIO and DPO. In LBO tests, cash above a minimum balance is often swept to repay debt in a cash sweep, and a revolving credit facility draws when cash would fall below it. Both are financing flows, so they must run through the cash flow statement and the debt roll-forward, never directly into the cash balance.
Transactions and Fees
LBO and merger tests add purchase accounting. The sources and uses must balance. Under Accounting Standards Codification (ASC) 805, transaction advisory costs are expensed as incurred, while debt financing fees are capitalized and amortized as interest. Goodwill is the purchase price less the fair value of the identifiable net assets acquired, with any write-ups creating deferred tax liabilities in a stock deal where the tax basis does not step up. The treatment of fees is covered in transaction costs and financing fees, and the allocation of price in purchase price allocation.
What Graders Look For
Graders typically check four things. Correctness comes first: the model balances in every period, cash ties to the cash flow statement and the returns or accretion figures follow from the assumptions. Then they look at whether the assumptions are clearly separated from calculations and labeled, so the model can be followed. Third, they check that the outputs make sense: cash should not go negative without a revolving credit facility drawing, leverage should fall as debt is repaid, cash taxes should not turn negative, and margins should stay within reason. Finally, in longer cases, they judge the interpretation, whether the candidate can say what the numbers mean for the deal.
A separate post on what interviewers look for in modeling tests covers presentation and process in more depth. The accounting, though, is what makes a model trustworthy, and it is the part that preparation on the three statements improves most.
