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.

Region
 

I don’t agree with your SaaS comment above. Generally SaaS is a high margined business and calling is low margin but then saying it adds to the bottom line doesn’t make sense. 

Like the unadjusted- only with a little bit extra.
 
The EBITA addback

I don't agree with your SaaS comment above. Generally SaaS is a high margined business and calling is low margin but then saying it adds to the bottom line doesn't make sense. 

Yep, that's because I'm a fool and mixed up low and high as I was typing.

Edited above, thanks

Remember, always be kind-hearted.
 

Adding on- regarding opex- I would say that it’s hard to differentiate as which item is more important- opex or gross margin. I know you mentioned opex was less important in your view- and that tended to hold true for me when I worked in industrials/C&I. However, for a lot of growth companies and in the TTM vertical, opex (especially R&D, FTE and marketing spend) are the huge drivers of profitability and vital to understand so that you have a good grip on unit economics. Routinely we see cuts in spending and then a top line and GPM (due to fixed portion of COGS) that will rapidly deteriorate.

Like the unadjusted- only with a little bit extra.
 

Hah - true. But in reality this was a great analysis, but to your point I feel like a similar walkthrough of a CF and BS would be quite helpful for some of the interns / analysts on WSO.

 

My entire career has been in fp&a (with some M&A - I’ve closed over $700M+ in acquisitions in 4 years, sole analyst on $40M+ acquisition) and have owned P&L’s for the past 2.

Great post - different industries all have little nuances but this is a great overview. I refer to my current company’s P&L as “mine” as I’ve built our current operating model. If it’s your first time reviewing, finding the connections between revenue streams and costs is key.

 
Most Helpful

Good post !

Some other quick ideas below:

- Did the company raise a lot of money recently to scale (eg a stable founder owned company created 20 years ago raised $50m from a growth investor at some point and hence you see Opex and in particular S&M grow a lot and become more than you would expect), on the other hand, is the company very cash constrained ? This is more qualitative of course 

- Besides accrual P&L how are the cash revenue and cash EBITDA looking, in particular for subscription businesses and/or telcos that have large IRU contracts but I guess that’s relevant for all businesses

- For high growth businesses, you also look at ARR 

- If the company is scaled enough, how are the growth rates benchmarking vs industry peers and is there a case or not for higher vs lower growth and why. For example if you’re the #3 player in a 10% growth industry but management forecasts 25% growth, they better have solid reasons to substantiate that - you already mentioned this point 

- You’re in PE but if you were to look at growth-type tech businesses where you’re basically dumping money in S&M, the LTV/CAC ratios and such because more important (as are things like cohort analysts, retention, etc.), but that’s deviating a bit 

- Obviously industry specific but in some case the gross margin could be dropping over time, in particular if you’re a reseller of some sort or have negative supply chain forces and low bargaining power

 

If you need to do it quick and dirty you can also just look at margins / growth rates. Where is the biggest growth coming from and why / what drives the projection? What’s the reason for GM / EBITDA increase and which item of COGS or SG&A drives this. This can help you vet CIMs quickly, as some bankers will project SG&A margins to drop by 15% with no real backup for it

 

If you need to do it quick and dirty you can also just look at margins / growth rates. Where is the biggest growth coming from and why / what drives the projection? What's the reason for GM / EBITDA increase and which item of COGS or SG&A drives this. This can help you vet CIMs quickly, as some bankers will project SG&A margins to drop by 15% with no real backup for it

This is an even better quick/dirty method, 1100% agree-if you have no other time, look at what the biggest % change is and what drives it, and if you can't find an answer, you have a great diligence point

Remember, always be kind-hearted.
 

Having been on both the investment side in PE and operating side (preparing adjustments) at this point, I'd add that you need to be highly critical (as in thinking critically, not being tonally critical towards the counterparty) of adjustments. In an ideal world, each adjustment would be a total that could be decomposed into various line items on the GL with backup in the form of receipts, invoices, payroll reports, etc. However, I think a lot of sellers cut corners and don't think as deeply about what makes a proper adjustment and what doesn't, because they aren't used to it. Coming up with a comprehensive schedule of adjustments for several years back without just making very rough estimates is a lot of work, even if recordkeeping is good. As an investor, you should have a process for figuring out what adjustments can be supported with "evidence" and what are estimates and probably discount anything estimated by some amount.

 

Awesome list. Good to think on COGS btw about whether or not there’s any tie to commodity pricing for the underlying and whether fluxes in those can cause unexpected margin pressure (only for materials-based businesses for the most part of course).

 

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