What Investment Bankers Should Know about Income Statements - dummies

What Investment Bankers Should Know about Income Statements

By Matt Krantz, Robert R. Johnson

Individual investors and investment bankers are often fixated on the income statement. Every quarter, investors eagerly await earnings season (a roughly three-week period during which major companies report their quarterly results). During earnings season, investors pore over the financial documents released by companies, especially the income statement.

There’s a good reason why investors pay such keen attention to the income statement: The income statement is what tells all interested parties, stock investors, bondholders, employees and, yes, investment bankers, how much the company earned during that quarter.

The income statement’s basic task is to show investors how much the company brought in by selling goods and services, and how much was left in profit after paying expenses.

The income statement adheres to very strict accounting guidelines, called generally accepted accounting principles (GAAP). All companies that trade on U.S. exchanges and file financial statements with the Securities and Exchange Commission (SEC) are required to follow GAAP. By following the same set of accounting rules, investment bankers are able to compare the financial results of different companies against each other.

Although all companies must follow these rules, there is often room for interpretation of these guidelines, and comparing one firm to another may not be an “apples-to-apples” comparison.

The income statement is used by investment bankers primarily to

  • Gauge the trajectory of the business. By reading the income statement, investment bankers can get a good idea where the company is on the spectrum of the firm’s lifecycle. The income statement, for instance, can show investment bankers if it’s a young company that’s growing rapidly or a lumbering giant that’s hitting the wall and struggling to find new businesses to tap.

  • Find out where a company’s objectives lie. If there’s one reason why investment bankers pay close attention to the income statement, it’s because other investors and company management pay close attention to it. If a company’s management, including the CEO, can’t find a way to drive profit higher, their high-paying jobs could be on the line.

    By scanning the income statement, investment bankers can in short order get a pretty good idea of what problems CEOs must solve in order to hang onto their lucrative jobs.

  • Understand the true drivers of the business. Companies are often best known for their higher-profile businesses, but the true driver is something else. The income statement cuts away any preconceived notions about which businesses are most important to a company and gets down to the facts.

If you’re an accountant or investor, you look at the income statement very differently than an investment banker does. Accountants look for inconsistencies or ways the companies overstate their profits. Investors examine the income statement for clues on whether the company would likely be a good investment. But investment bankers look at financial statements trying to find ways to approach the companies with ideas of ways to improve results.

For investment bankers, the focus is on certain line items on the income statement that are the most telling for their purposes, including

  • Revenue: Revenue is the amount of total sales that’s being hauled in by a company. Revenue is sometimes called sales or “the top line.” Investment bankers pay very close attention to revenue because it’s a measure of the amount of dollar volume running through the company. Revenue is also the basis for measuring how quickly a company is growing.

  • Cost of goods sold (COGS): Companies don’t get to keep all their revenue, as hard as they might try. There are costs associated with producing a product or service. Those direct costs include buying raw materials.

  • Gross profit: A company’s gross profit is how much is left of revenue after paying COGS. Gross profit is a good indication of how profitable a company’s line of business is before mucking up the analysis with peripheral overhead costs, some of which are more controllable than direct costs are.

  • Selling, general, and administrative costs (SG&A): Companies don’t just need to buy raw materials to get a product to market. There are salespeople to pay, not to mention advertising costs and executive paychecks to deal with. These overhead costs are often indirect costs by investment bankers.

  • Operating income: A company’s operating income is how much it keeps from revenue after paying both direct and indirect costs. Operating income gives investment bankers a good indication of a company’s profitability, excluding the bite from Uncle Sam in the form of taxes.

  • Interest expense: Companies that borrow money from bondholders or other lenders typically need to make periodic interest payments on those loans. The portion of the expenses paid in the current period is shown in the interest expense line item.

  • Income taxes: Companies must pay taxes, too. Taxes can be a significant cost for companies, and tax bills may even come into play when making decisions on business moves or where even to physically locate a business. One consideration in mergers, for instance, has to do with managing tax bills.

  • Net profit: Investment bankers arrive at the bottom line, or net profit. Net profit tells the investment bankers how much the company earned after subtracting all the costs.

These line items apply to most manufacturing firms and even many service firms like restaurant chains. Financial companies are unique, and the line items on the income statement are read differently.