In Focus: How to read an income statement

Well-executed financial due diligence is one of the most effective means by which a private equity firm, and especially its operating partners, can mitigate risk and drive returns. The ability to draw and support important deal assumptions despite ambiguity can distinguish firms from one another and determine success or failure in a bidding process.


Where does revenue come from?

Developing a view on the revenue landscape of a company is first in order of importance when conducting financial due diligence. It typically provides key insights that can be used to assess the company’ capabilities and activities against the functions most valued by customers.

As early as possible, segment sales by geography, channel, product line and end-customer type. These items should be clearly described in the initial data request list. It is also vital to understand average selling price trends, rebates, returns and discounts, as well as the sales organisation topology, which supports total company revenue.

All requests should encompass sufficient data to show historical trends. This data request will vary by business type and should answer questions about abnormal increases or declines, or new product or channel strategy deployment. Early in the due diligence process, sellers may be reluctant to share specific customer or product-line data, but pursue this data so potential issues can be flagged and further analysed.

The analysis performed should produce the following outputs: profit margins, average selling price trends, geographic and currency considerations, and sales force structure. These outputs should be reflected in the deal model as appropriate.


How are salespeople incentivised?

Sales compensation plans can be powerful tools to direct sales resources to focus on particular attributes of the business. The structure of plans also provides an explicit framework for salespeople to optimise their own compensation. A salesperson with a compensation plan focused exclusively on revenue dollars who also has the ability to affect price may sell products at a lower margin towards the end of a particular month, quarter or year in order to meet compensation plan targets. A purely gross-margin-driven plan will result in high gross margins on potentially low sales dollars.

Analyse the degree to which sales compensation plans are fixed or variable, in order to correctly model the relationship between sales and selling costs over the intended holding period. Changes in revenue, average selling price compression, gross margin increases and employee attrition are all potential effects of changes made to sales compensation plans. As such, it is important that data requests provide the information required to highlight significant changes to compensation plans made over the last several years and the impacts, if any, which resulted.

How realistic are new product/new market predictions?

Often, a seller’s case for an increased future value of its business is predicated on its successful entry into new markets. New markets may be defined as geographic diversification using additional sales channels or previously unexplored go-to-market methodologies. The company may also enter new markets through product development efforts to access the markets it previously could not serve.

Geographic diversification brings its own set of challenges. The items below should be considered when reviewing management’s assumptions:

•   Payment terms may be longer or shorter than in the rest of the business

•   Credit risk must be assessed and it may not be normal practice for customers to provide detailed financial information

•   Local partners and the company may have to share risk and rewards in ways previously not done

•   Regulations may require customs compliance and can carry significant penalties for non-compliance

•   Foreign currency risk may exist if currencies other than the company’s primary currency are used

 

The company may access new markets through partners such as distributors and value-added resellers, or through e-commerce. Analysing the following items will provide insight into the implications:

•   Marketing cost, if required

•   Time required for new channel partners to become productive relative to targets set

•   Fixed and variable components of compensation of channel partners

•   Credit risk and credit-level management, where applicable

•   Cannibalisation of revenues previously served by company’s direct sales force

•   Alignment of sales force cost structure if alternative channels are used in certain geographies or for certain product lines

 

The cost of educating new value-added resellers, distributors or sales representatives not employed directly by the company is easily understated. The amount of time required for those sales representatives and distributors to become productive needs to be factored into projections. Many models presented by sellers carry optimistic assumptions around sales force productivity and the amount of cost required to continue to service and support those distributors until they are able to sell products on behalf of the company.

Another key consideration when attempting to project revenue growth is to understand both customer and product profitability trends. During the due diligence process, request data that will enable a view on the profitability (at gross margin level) of the company’s top and highest volume product lines to be developed. Doing so allows various revenue cases to be properly reflected in the deal model.

 

Are there too many products?

The profitability of future revenue forecasts can be affected by increases or decreases in the actual number of products or product varieties sold. When analysing the products sold by the company both today and those expected to be launched (and contribute significant revenue to future periods), note that maintaining a certain number of product lines carries its own costs.

A large variety of distinct products or services (also otherwise known as stock-keeping units or SKUs), particularly in environments that demonstrate volatile or rapidly changing forecasts or have short product life cycles, can lead to excess and obsolete inventory. There are also costs, such as sales and marketing and R&D, in continuing to sell and update a wide and deep product portfolio. While it is important to offer a diverse product portfolio to meet customer demands, it is healthy to question the number of products required and the degree to which selling unprofitable or highly complex products truly add value.

Can cost increases be passed on?

Early in the due diligence effort, develop a view of the cost/price dynamics faced by the target company. To perform this analysis, the impacts of price changes, product mix shifts, material costs and even currencies must be largely isolated.

Due diligence will provide a sense of the periods when cost increases were more or less able to be passed to the customer through higher prices. Obtaining data by product line will reduce errors in the analysis regarding product-level mix over time. An analysis that shows average selling price (ASP) trends, product-level mix and margins and geographic trends will help isolate the impacts of material cost increases to profitability. Where a business uses multiple currencies, understand these items on a comparable (that is, foreign exchange neutral) basis.

While selling price trends and underlying cost dynamics must be understood individually, it is also critical to understand their relationship to one another. Historical data, particularly over time periods where significant changes occurred, is important in determining the company’s ability to avoid absorbing price increases from its supply base and the extent to which it can pass through those costs to its customers. Some companies may not have contractual protection against input cost increases, which only makes an empirical analysis even more important.

Timing is a key consideration when evaluating the short- to medium-term impacts of cost increase or decrease pass through via price. The ability to hold on to temporary advantages can result in substantial benefits over time, just as the inability to do so can be detrimental.

It may be helpful to examine periods when costs exceeded the company’s expectations by reviewing the purchase price variance (PPV) line of the cost of goods sold (COGS) detail. PPV variances occur when costs are greater, or less, than the standard costs set by companies in their cost accounting plans. High PPVs will indicate periods where costs increased, and vice versa.

 
How much are staff being paid?

Modelling labour cost requires understanding where employees are located, the functions performed and the categories of cost included in total labour cost. Hourly employees, salaried employees, contract workers, temporary labour and terminated employees with ongoing costs should all be considered. Pay attention to benefits such as pensions.

Consider employee hires and tenure when modelling annual salary increases and note the fixed versus variable compensation portion of cash remuneration across all categories of employees. Many labour cost analyses have insufficiently included the cost of rising benefits, only to model them as a percentage of wages when in fact they often grow at a faster rate than employee salaries.

An early goal of due diligence should be to map detailed individual employee compensation, by function, by the financial statement sections in which they reside or in the divisions or geographies in which they work. Having a bottoms-up view of the labour costs of a business and linking that detail to the company’s financials will provide a solid starting point for modelling anticipated changes such as increases or decreases in headcount.

What are the big operating expenses?

Lease obligations are often held flat over model time frames. However, a review of key lease provisions will provide the information required to correctly model increases over the remaining life of the lease.

IT support costs for older software systems may increase over time, and support costs for recently implemented systems may have been bundled into the purchase price and thus not be reflected in the last one to two years of income statement data. Telecom costs are typically contract-based for data and land lines but variable for mobile costs. While general insurance costs are fixed over any particular year, the company may be exposed to volatile insurance markets such as wind, flood or earthquakes.

Professional service provider costs should be viewed in sufficient detail to understand which items are likely to be recurring, such as audit and some legal, and which were one-time in nature and are to be excluded from future period forecasts.

Other discretionary items such as travel and entertainment should be reviewed and understood within the context of the frequency of contact made with customers or suppliers, or if the costs were related to individual projects such as enterprise resource planning system implementation or the opening of a new location which may have driven some component of non-recurring expense. 

 

Shahriyar Rahmati is a vice president of finance in the Operations group at The Gores Group in Los Angeles, California, where he is responsible for portfolio company financial oversight and controls as well as leading financial due diligence activities.

This is an abridged extract from ‘Private Equity Company Due Diligence’, a Private Equity International book edited by Shahriyar Rahmati and published in July 2012.