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,
