M&A Fundamentals – Understanding the Income Statement from an M&A Perspective
The income statement, in some accounting standards called the Profit and Loss account, shows revenue, expenditure and profit for an accounting period (usually a year).
Arithmetically it can be expressed as:
Revenue – Expenditure – Interest Payment – Income Taxes = Net Income
Diagram 1 below shows a typical income statement layout.
Diagram 1 – Layout of Income Statement (Profit and Loss)
In an M&A transaction the buyer needs to look beyond this simple calculation to understand the underlying level of income free of any unusual or non-recurring costs or revenues.
At a minimum the seller would be expected to provide a break down of revenues, costs of sales and gross income into markets segments and product groups. Even individual customers or products might need to be broken out if the revenues or income associated with them are material to the M&A transaction.
Accessing financial data at this level of granularity can be a particular challenge when the subject of the M&A transaction is a smaller private company. Often these companies will rely on rudimentary finance and sales statistics systems in comparison to the detailed reports generated by the sophisticated ERP systems of a large corporate enterprise. If the M&A target has no established product and customer profitability reporting systems, any information provided will be the result of a one-off exercise. How much reliance can the buyer place on this information in the context of an M&A transaction? Reports from corporate systems are subject to regular monthly reviews and accountability processes. These find and eliminate errors. One-off reports generated for an M&A due diligence are not subject to this continuing level of scrutiny.
The seller will also be expected to produce historical income statement information for several years before the date of the proposed M&A transaction, and a forecast for a minimum of 12 months and ideally at least 3 years into the future. The buyer will use this information to track changes from year to year in each element of the income statement.
Diagram 2 below illustrates this process:
Diagram 2 – Year to year tracking of income statement
The sell side of the M&A transaction will be asked to provide explanations of year-to-year changes. In M&A jargon these are often referred to as bridges. They help the buyer drill down below the high-level numbers and understand the actions and events that are driving changes in the income statement. For example, in the explanation for gross income improvement in 2008 offered in diagram 2, the buyer will be prompted to drill down further to understand the reason for the fall in raw material costs. Is it a one-off movement in commodity prices, or an intervention by purchasing management to find cheaper vendors or more cost-effective materials? Why is this important? A commodity price movement can eventually swing in the other direction, a purchasing intervention can be a permanent improvement in profitability. Year to year analysis is also likely to cover any unrealistic growth elements that have been built into revenue and income projections.
In a similar vein the sell-side of the M&A transaction will be asked to provide a cost code by cost code analysis of operating expenses. Changes in expenditure will again be tracked from year to year to understand any one-off events that distort a clear view of underlying profitability.
Why is this concept of year-to-year sustainable income so important to M&A professionals? One thing to remember about any M&A transaction is that you are buying the future income and cash flows of the target company. As a baseline you will want to understand if the underlying sustainable income of the M&A target, free of any distorting one-off gains, will justify the expected purchase price.
About The Merger Training Institute
We provide practical, in-career mergers and acquisitions training for boards, executives and professionals in global corporations.
Our short, intense M&A courses are designed for executives needing to understand best M&A practice or adding new M&A responsibilities to their existing roles.
The courses are taught by tutors with hands-on M&A experience gained as part of corporate management teams. As well as being academically rigorous they are rich with case studies and real-world examples based on our tutor’s practical mergers and acquisitions experience.
Our course participants come from a wide range of industries and roles including general management, business development, strategy, marketing, finance, human resources, operations and legal.
Our Mergers and Acquisitions Training Courses
Core Mergers and Acquisitions Skills Training Course
The Core Mergers and Acquisitions Skills programme (M&A training course) is a three- day programme that teaches all the commercial and technical skills you will need to confidently lead or support a successful M&A transaction.
Our expert tutors guide you through the M&A process from strategy and deal origination to valuation, due diligence, deal structuring, contract negotiation and post-merger integration.
M&A Due Diligence Training Course
The M&A Due Diligence Training Course is a two-day programme that offering a solid grounding in the techniques used by some of the world’s most successful companies to assess risks, evaluate synergies and confirm the strategic fit of an M&A target. The course is designed specifically for executives involved in corporate M&A.
Successful Post-Merger Integration Training Course
The Successful Post-Merger Integration Training Course is a two-day programme that provides a solid grounding in the post-merger integration techniques used by some of the world’s most successful companies to deliver value from their M&A transactions.
Across the two days of the course you move from the key decisions made in the pre-deal phase, through the critical first 100 days and on to full synergy delivery. The course covers the post-merger integration issues most likely to arise in each business function and the most important business processes.
Advanced Business Valuation Training Course
The Advanced Business Valuation training course is a two-day expert level business valuation training course that teaches participants how to prepare robust business valuations in the context of a corporate M&A transaction.
Our expert tutors move you past the stage of plugging numbers into a standard spreadsheet and help you explore how risk, synergies and the quality of the target company might impact its value.