The selling company’s income statement contains lots of important information for the M&A offering document. A Buyer wants to make sure he is aware of all the expense and profit information of the company before proceeding with an offer.
Gross profit, gross margin, and SG&A
Gross profit is the amount of revenue that remains after the cost of producing sales is subtracted. For example, if sales are $100 million and the cost of goods sold is $40 million, the gross profit is $60 million. Gross margin is the percentage calculation of gross profit. In this example, the gross margin is 60 percent.
Contrary to popular usage, gross profit and gross margin aren’t interchangeable. Any time you see the word margin, that means percentage. Far too many businesspeople refer to gross profit as gross margin, saying, “The company has $10 million in gross margin.” Actually, the company has $10 million in gross profit. If revenues were $100 million, the company would have a 10 percent gross margin.
Gross profit is important because it’s variable — it fluctuates based on revenue levels and pricing. Gross profit needs to be high enough to cover the other costs of the business, called SG&A.
SG&A is comprised of salaries, rent, insurance, utilities, supplies, and so on. Although SG&A includes both fixed and variable costs, most companies have a good idea of their SG&A, and therefore know exactly how much it needs to generate in sales to create sufficient gross profit to cover SG&A.
When companies fail to generate enough gross profit to cover SG&A, that’s a bad sign! If a company lowers its prices in order to generate higher sales, those lower prices may result in lower gross profit, and if gross profit dips below SG&A, the company is in trouble.
Other income and expenses
A good M&A offering document should detail the nebulous “other income” and “other expense” categories. Essentially, these categories are revenues or expenses that aren’t related to the underlying nature of the company.
If a t-shirt manufacturer sells a piece of equipment for $50,000, it reports that income on the income statement as “other income.” If that company also terminates an employee and pays that employee a $20,000 severance, it should report that expense in the “other expense” section. (Hopefully, firing employees and paying severance isn’t a regular event.)
Although other income and other expenses should appear in the offering document, make sure you adjust the EBITDA (earnings before interest, taxes, depreciation, and amortization) for those other income or other expense items. Failure to clearly delineate other income and other expenses may blur the company’s actual EBITDA (EBITDA generated as result of the company’s normal operations and not as the result of one-time expenses or income).