Associate guide on analyzing an income statement

I wanted to share some insights that I've learned after a couple-ish years in PE about how to go through the income statement of a company. I came from Bain & Company before PE, so I never really looked at the financials, and I wish I had a quick and dirty guide, so this is the one that I'd like to share.

Mandatory disclaimer: I don't claim to be an expert. I'm probably wrong in a few places. When you find an error, or a better way to think about something, please add to this and correct it in the comments below. I'm a recovering consultant, so this will sound consultanty--any insights from the banker side are well appreciated.

The basic framework is this: Understand how they make money, understand where they spend money, and understand what makes the YoY growth or decline change. If I can answer those questions, then I know that I have a good place

• Revenue: I have a handful of standard questions and then some industry specific ones as I dive in:
  • Main questions: How is revenue generated? Which revenue streams make up the highest share of revenue? What is driving the growth of each of the revenue streams, and what are the assumptions behind those drivers?
  • Industry: Then other questions come up that are a bit more specific to the type of industry. For example, if the company is subscription based, then I want to know how long the subscriptions are. If it's more of a commodity, I want to understand how sensitive the company is to commodity fluctuations, etc. Basically, I need to understand what would make the revenue go up or down and how "sticky" those forces are
  • Associate Takeaways: You'll find that in most complex models there's really only some 2-5 assumptions driving the majority of the revenue growth. When your VP asks you why revenue is going up at XX%, you should be able to say, "the growth is driven by A, B, and C, so we need to diligence if that's what's going on or if the bankers are just blowing smoke." VPs love drivers. Write these drivers down.
• COGS/GM: Similar to Revenue above
  
  • Main questions: What are the main drivers of COGS? How do they relate to each product line/service? Are there specific lines that require higher COGS and this have a lower GM? Are these driving the growth, or are the high margin lines driving growth? Again, the idea is to get down to the drivers of GM improvement, and see if they make sense. Make sure to write these down as well.
  • Industry: There will, again, be other questions that are specific to the company itself and the industry that you'll want to ask. This is also the point at which it might make sense to do some desktop research and see what comparable company's GMs are. For example, if it's a food manufacturer, then it would make sense to go check it against Tyson or something so that you have the quick fact of "this is higher/lower that Tyson's GM." When your VP inevitably asks, "Why is it that they are higher/lower than Tyson's?" then you'll want something in your back pocket, but usually if it's a first pass, it's good enough to say, "We don't know yet because this was the first pass, but I can add that to the list of diligence items."
  • Associate takeaways: Make sure that you know what the historical and projected GM is in general terms (e.g., "Management had it at ~30% but expects it to grow to ~35%) because your VP will probably ask you. Drivers may be a bit harder t find as most people just sort of assume a certain GM as time goes on and nothing really drives the model; if that's the case, it's okay to call that out and not have a specific macro/company driver.
• Opex. This part has historically been a little less important for me, but still, some nice ideas on what to look for:
  
  • Overview: You'll basically want to understand which buckets of Opex are the largest ones. These are going to be the only things worth talking about, especially if you plan on reducing them once you take over the company.
  • Metrics: Here is where you can do some of those sales metrics, like CAC and such, because you have SG&A, etc. Opex to me is more about finding efficiency ratios than it is about understanding costs, but it's still great to benchmark because there's probably a good amount of fat to cut out when acquiring a company.
  • Associate takeaways: Have the biggest Opex buckets and be ready to discuss them with your VP. If you have the time, model out some industry specific metrics and then have those as a quick tear-off so that you can appear intelligent
• EBITDA: The bread and butter of the buyout
  
  • Overview: EBITDA is really just the combination of Revenue, GM, and Opex, so if you've understood the lines above, then EBITDA will be pretty easy to discuss. The trick here is to understand exactly which of those buckets has the biggest outsized impact on EBITDA, e.g., which one is biggest. For example, a low GM company with a high Opex base will have much better returns of you reduce Opex than if you grow sales one more dollar, but for something like SaaS where it's high GM, an additional dollar of revenue is basically gravy and almost flows down entirely to the bottom line
  • A word of caution about depreciation: there's a big case to be made about using EBIT instead of EBITDA for fixed-asset heavy businesses. If you have a, I dunno, dying machine that dyes fabric by the square foot, and it only can do 1B sqft before breaking, then realistically you should factor in the total life left in the machine--in other words, you should model out the depreciation because it's an actual cost of creating the thing, and you can allocate it per item created.
  • Less capital intensity doesn’t need this, but I'd be hard pressed to not think harder about D&A when looking at something that uses a lot of fixed assets
• After EBITDA, I really don't tend to look at anything unless there's a massive jump between EBITDA and net income. If that is the case, then I see what the massive jump is and I get to the driver behind it.
• For EBITDA adjustments, I like to break those down and, again, look for the biggest item and see if I think it's reasonable or not. There are plenty of threads here on WSO that go through some comical add-backs--I'd check for everything, but the biggest 2-3 are the likely culprits. Management fees, interest, etc. are fine--adjusting for COVID by saying "revenue if COVID didn't happen" is not.

Some things you've probably noticed as you've looked this over:

• Biggest number, biggest change: The biggest things are the most important things. Always check for 2 main things: 1) biggest number in a bucket and 2) biggest change in a bucket. For example, if revenue is 90% contractual and 10% ad-hoc, then focus on the contractual revenue and understand what drives it. Conversely, if contractual revenue is growing at 0% YoY but ad-hoc s projected to grow 25% YoY, then you should know why that's the case as well, even if the dollar value is lower. This is especially helpful during management calls.
• Why and what: Digging into "Why" questions helps you understand. You should always be questioning why something is big or growing, and dig down until you run out of resources or you find the answer. Questions like, "Why do they think that this revenue bucket won't grow" or "Why is Opex not increasing at the same clip as revenue" are helpful. "What" questions like "What is driving this revenue" and "What are GMs across the industry" are always helpful as well, but I like to focus on "Why" first because "What" seems to come later.
• Gut checking: There are certain ideas that are generally true in almost every Proforma model: EBITDA margin should grow, Gross margin should grow, Revenue should scale faster than Opex, etc. Keep all of these in the back of your head when you look at the IS as a whole, and note whenever something doesn't follow the general guidelines. You'll often find a reason for it (e.g, EBITDA is down because of big hires, or something like that), but it's helpful to be able to call out and dig into

That's my mind/data dump for this Wednesday morning. Hope it's helpful.