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Before getting into M&A analysis, it is important to give a brief overview of the six major statements in a standard financial operating model and how they work together:

1. Income statement

2. Cash flow statement

3. Balance sheet

4. Depreciation schedule

5. Working capital schedule

6. Debt schedule

The general concepts in this chapter are necessary to understand the merger processes in the subsequent chapters.

The Income Statement

The income statement measures a company's profit (or loss) over a specific period of time. A business is generally required to report and record the sales it generates for tax purposes. And, of course, taxes on sales made can be reduced by the expenses incurred while generating those sales. Although there are specific rules that govern when and how those expense reductions can be utilized, there is still a general concept:

A company is taxed on profit. So:

However, income statements have grown to be quite complex. The multifaceted categories of expenses can vary from company to company. As analysts, we need to identify major categories within the income statement in order to facilitate proper analysis. For this reason, one should always categorize income statement line items into nine major categories:

1. Revenue (sales)

2. Cost of goods sold (COGS)

3. Operating expenses

4. Other income

5. Depreciation and amortization

6. Interest

7. Taxes

8. Nonrecurring and extraordinary items

9. Distributions

No matter how convoluted an income statement is, a good analyst would categorize each reported income statement line item into one of these nine groupings. This will allow the analyst to easily understand the major categories that drive profitability in an income statement and can further allow him or her to compare the profitability of several different companies – an analysis very important in determining relative valuation. We will briefly recap the line items.

Revenue

Revenue is the sales or gross income a company has made during a specific operating period. It is important to note that when and how revenue is recognized can vary from company to company and may be different from the actual cash received. Revenue is recognized when “realized and earned,” which is typically when the products sold have been transferred or once the service has been rendered.

Cost of Goods Sold

Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold by a company. These are the costs most directly associated with the revenue. COGS is typically the cost of the materials used in creating the products sold, although some other direct costs could be included as well.

Gross Profit

Gross profit is not one of the nine categories listed, as it is a totaling item. Gross profit is the revenue less the cost of goods sold. It is often helpful to determine the net value of the revenue after the cost of goods sold is removed. One common metric analyzed is gross profit margin, which is the gross profit divided by the revenue.

A business that sells cars, for example, may have manufacturing costs. Let's say we sell each car for $20,000, and we manufacture the cars in-house. We have to purchase $5,000 in raw materials to manufacture the car. If we sell one car, $20,000 is our revenue and $5,000 is the cost of goods sold. That leaves us with $15,000 in gross profit, or a 75 percent gross profit margin. Now let's say in the first quarter of operations we sell 25 cars. That's 25 × $20,000, or $500,000 in revenue. Our cost of goods sold is 25 × $5,000, or $125,000, which leaves us with $375,000 in gross profit.

Operating Expenses

Operating expenses are expenses incurred by a company as a result of performing its normal business operations. These are the relatively indirect expenses related to generating the company's revenue and supporting its operations. Operating expenses can be broken down into several other major subcategories. The most common categories are as follows:

• Selling, general, and administrative (SG&A): These are all selling expenses and all general and administrative expenses of a company. Examples are employee salaries and rents.

• Advertising and marketing: These are expenses relating to any advertising or marketing initiatives of the company. Examples are print advertising and Google Adwords.

• Research and development (R&D): These are expenses relating to furthering the development of the company's products or services.

Let's say in our car business we have employees who were paid $75,000 in total in the first quarter. We also had rents to pay of $2,500, and we ran an advertising initiative that cost us $7,500. Finally, let's assume we employed some R&D efforts to continue to improve the design of our car that cost roughly $5,000 in the quarter. Using the previous example, our simple income statement looks like this:

Other Income

Companies can generate income that is not core to their business. As this income is taxable, it is recorded on the income statement. However, since it is not core to business operations, it is not considered revenue. Let's take the example of the car company. A car company's core business is producing and selling cars. However, many car companies also generate income in another way: financing. If a car company offers its customers the ability to finance the payments on a car, those payments come with interest. The car company receives that interest. That interest is taxable and is considered additional income. However, as that income is not core to the business, it is not considered revenue; it is considered other income.

Another common example of other income is income from noncontrolling interests, also known as income from unconsolidated affiliates. This is income received when one company has a noncontrolling interest investment in another company. So when a company (Company A) invests in another company (Company B) and receives a minority stake in Company B, Company B distributes a portion of its net income to Company A. Company A records those distributions received as other income.

EBITDA

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a very important measure among Wall Street analysts. EBITDA can be calculated as Revenue – COGS – Operating Expenses + Other Income.

It is debatable whether other income should be included in EBITDA. There are two sides to the argument.

1. Other income should be included in EBITDA. If a company produces other income, it should be represented as part of EBITDA, and other income should be listed above our EBITDA total. The argument here is that other income, although not core to revenue, is still in fact operating and should be represented as part of the company's operations. There are many ways of looking at this. Taking the car example, we can perhaps assume that the financing activities, although not core to revenue, are essential enough to the overall profitability of the company to be considered as part of EBITDA.

2. Other income should not be included in EBITDA. If a company produces other income, it should not be represented as part of EBITDA, and other income should be listed below our EBITDA total. The argument here is that although it is a part of the company's profitability, it is not core enough to the operations to be incorporated as part of the company's core profitability.

Determining whether to include other income as EBITDA is not simple and clear-cut. It is important to consider whether the other income is consistent and recurring. If it is not, the case can more likely be made that it should not be included in EBITDA. It is also important to consider the purpose of your particular analysis. For example, if you are looking to acquire the entire business, and that business will still be producing that other income even after the acquisition, then maybe it should be represented as part of EBITDA. Or maybe that other income will no longer exist after the acquisition, in which case it should not be included in EBITDA. As another example, if you are trying to compare this business's EBITDA with the EBITDA of other companies, then it is important to consider if the other companies also produce that same other income. If not, then maybe it is better to keep other income out of the EBITDA analysis, to make sure there is a consistent comparison among all of the company EBITDAs.

Different banks and firms may have different views on whether other income should be included in EBITDA. Even different industry groups' departments within the same firm have been found to have different views on this topic. As a good analyst, it is important to come up with one consistent defensible view, and to stick to it. Note that the exclusion of other income from EBITDA may also assume that other income will be excluded from earnings before interest and taxes (EBIT) as well.

Let's assume in our car example the other income will be part of EBITDA.

Notice we have also calculated EBITDA margin, which is calculated as EBITDA divided by revenue.

Depreciation and Amortization

Depreciation is the accounting for the aging and depletion of fixed assets over a period of time. Amortization is the accounting for the cost basis reduction of intangible assets (e.g., intellectual property, such as patents, copyrights, and trademarks) over their useful lives. It is important to note that not all intangible assets are subject to amortization.

EBIT

EBIT is EBITDA less depreciation and amortization. So let's assume the example car company has $8,000 in D&A each quarter.

Notice we have also calculated EBIT margin, which is calculated as EBIT divided by revenue.

Interest

Interest is composed of interest expense and interest income. Interest expense is the cost incurred on debt that the company has borrowed. Interest income is commonly the income received from cash held in savings accounts, certificates of deposit, and other investments.

Let's assume the car company has taken out $1 million in loans and incurs 10 percent of interest per year on those loans. So the car company has $100,000 in interest expense per year, or $25,000 per quarter. We can also assume that the company has $50,000 of cash and generates 1 percent of interest income on that cash per year ($500), or $125 per quarter.

Often, the interest expense is netted against the interest income as net interest expense.

EBT

Earnings before taxes (EBT) can be defined as EBIT minus net interest.

Notice we have also calculated EBT margin, which is EBT divided by revenue.

Taxes

Taxes are the financial charges imposed by the government on the company's operations. Taxes are imposed on earnings before taxes as defined previously. In the car example, we can assume the tax rate is 35 percent.

Net Income

Net income is calculated as EBT minus taxes. The complete income statement follows.

Nonrecurring and Extraordinary Items

Nonrecurring and extraordinary items or events are income or expenses that either are one-time or do not pertain to everyday core operations. Gains or losses on sales of assets or from business closures are examples of nonrecurring events. Such nonrecurring or extraordinary events can be scattered about in a generally accepted accounting principles (GAAP) income statement, so it is the job of a good analyst to identify these items and move them to the bottom of the income statement in order to have EBITDA, EBIT, and net income line items that represent everyday, continuous operations. We call this “clean” EBITDA, EBIT, and net income. However, we do not want to eliminate those nonrecurring or extraordinary items completely, so we move them to the section at the bottom of the income statement. From here on out we will refer to both nonrecurring and extraordinary items simply as “nonrecurring items” to simplify.

Distributions

Distributions are broadly defined as payments to equity holders. These payments can be in the form of dividends or noncontrolling interest payments, to name the major two types of distributions.

Noncontrolling interest is the portion of the company or the company's subsidiary that is owned by another outside person or entity. If another entity (Entity A) owns a noncontrolling interest in the company (Entity B), Entity B must distribute a portion of Entity B's earnings to Entity A.

Net Income (as Reported)

Because we have recommended moving some nonrecurring line items into a separate section, the net income listed in the previous example is effectively an adjusted net income, which is most useful for analysis, valuation, and comparison. However, it is important to still represent a complete net income with all adjustments included to match the original given net income. So it is recommended to have a second net income line, defined as net income minus nonrecurring events minus distributions, as a sanity check.