How Investment Bankers Adjust the Income Statement with Different Assumptions - dummies

How Investment Bankers Adjust the Income Statement with Different Assumptions

By Matt Krantz, Robert R. Johnson

Unlike many other users of financial statements, investment bankers rarely accept the financial statements at face value. To glean insights about where the business may be headed, and what kinds of financial products the company may need, investment bankers tweak the numbers for their own analysis purposes. All accountants must operate under the same rules, but those rules allow for some maneuvering.

Look at financials in a new way: Pro-forma results

Investment bankers largely look at financial statements as ancient history. And it’s true that even a quarterly statement may be a month old before it’s filed to the SEC’s EDGAR system, and by then, the business may have changed.

Given the backward-looking nature of financial statements, investment bankers try to use information from the past to tell something about the future. That’s the role of so-called pro-forma analysis. In Latin, pro forma means “as a matter of form.” In a pro-forma analysis, Investment bankers take the financial statements, including the income statement, and make hypothetical adjustments to them.

An investment banker thinking about pitching a buyout candidate to a company, for instance, may add that target company’s revenue to the buyer’s revenue on the income statement. By making estimates based on the past income statement, the investment banker can attempt to see how much the deal may add to the purchasing company’s bottom line.

Forming these hypothetical financial models can help investment bankers see how proposed changes to the business will likely affect its results.

Find out all about net operating profit after tax

One of investment bankers’ favorite adjustments to the income statement is net operating profit after tax (NOPAT). NOPAT is a way to look at a company’s profit to remove the distortion of debt and interest costs. NOPAT is calculated as follows:

NOPAT = Operating Income × (1 − Corporate Tax Rate)

Investment bankers like to look at NOPAT as a way to see how profitable a company is, leaving out the influence of the costs of debt financing. Examining NOPAT gives investment bankers an idea of how much debt a business can theoretically support before the interest payments become too onerous.