Chapter 7
IN THIS CHAPTER
Spotting interesting trends in the income statement
Kicking the tires of companies by analyzing the balance sheet
Appreciating the importance of tracking cash flow
Finding the lurid details about a company buried in the proxy statement
When you go to the doctor, you end up sharing parts of your body or personal concerns you don’t normally divulge to just anyone. It’s the professional relationship you have with your doctor that makes you feel free to open the kimono, literally and figuratively.
A similar situation exists between investment banks and their clients. Companies commonly share detailed aspects of their business with close financial advisors. It’s part of the relationship between investment banks and companies, and a big reason why the industry is so closely regulated — that information has great value.
But even though companies often share privileged information with investment bankers, investment bankers must do their part to research a company in order to understand it better. And when it comes to getting to know a company, even beyond what the CEO may tell an investment banker, the financial statements are hard to beat.
A company’s financial statements break down exactly how the firm is performing financially, how it got there, what kind of economic condition it’s in and even a little bit about how it’s positioned for the future. Information contained in the financial statements is generally considered to be the base camp from which companies and their investment bankers must start before building more complex financial products and planning for the future.
In this chapter, you find out about the primary financial statements investment bankers pay the most attention to: the income statement, balance sheet, and statement of cash flows. And since the proxy statement is such a treasure-trove of company information, we explore that document, too, from an investment banker’s perspective.
Individual investors 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 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.
The income statement is used by investment bankers primarily to
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 may overstate their profits or appearance of success. 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
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.
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 (see Chapter 6), 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.
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:
Investment bankers like to look at NOPAT 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.
The income statement is fertile ground for investment bankers looking for holes in a business that may be filled with some financial products. Part of the magic investment bankers subject the income statement to is based on financial ratios (see Chapter 8). Another technique is comparing a company’s financial statements to the industry (as shown in Chapter 9). But there are opportunities to spot just by glancing at the income statement, including the following:
The balance sheet is a snapshot in time of the financial health of a company. In its simplest form, the balance sheet is a financial statement that shows all the assets the company owns and all the liabilities that it owes based primarily on historical cost or book value.
Investment bankers with a practiced eye and attention to detail can take a quick glance at a balance sheet and identify a company’s financial strengths and weaknesses. The balance sheet gives investment bankers a look at the resources and liabilities a company has at its disposal, critical information when it comes to pitching financial products to the company.
Investment bankers have a unique way of looking at the world, and that view extends to the balance sheet. In this section, you find out the key elements of the balance sheet to investment bankers.
Investment bankers might crack open the balance sheet by first examining what the company has. All the companies’ possessions are listed as assets and placed into understandable groups:
Accumulated depreciation: When companies buy an asset, whether a machine or building, the passage of time takes a toll on that asset and typically reduces its value. Accountants require the companies to estimate how much value has likely evaporated due to the passage of time, and this is known as depreciation.
Depreciation may be a cost, but it doesn’t cost the company any of its cash. This characteristic is important to remember later in this chapter when you read about the statement of cash flows.
Goodwill: Goodwill is one of those assets that investment bankers know have value but have trouble describing. Goodwill is a catchall term to describe assets that have value, but generally aren’t tangible. Goodwill is often associated with copyrights, trademarks, and brand names, for instance.
One of the most common ways for companies to accumulate goodwill is when they buy another company for more than the book value of the company on the balance sheet. The difference is goodwill.
You have to spend money to make money. That’s just the reality of business. And the bills companies face, or the things they owe, show up in the liabilities section of the balance sheet, which includes the following:
Equity is one of those words in finance that can have many different meanings. In investment banking, the term equity is often used synonymously with stock, for instance. But when talking about the balance sheet, the term equity usually refers to the value of the shareholders’ ownership of the company. Another good way to think of equity in terms of the balance sheet is the difference between assets and liabilities.
The balance sheet for an investment banker serves a similar role as blood work for a doctor. When you go to the doctor, and blood is drawn, the physician can get a snapshot of your health at the current time. The blood work tells the doctor more about long-term trends or attributes about your health. Similarly, investment bankers use the balance sheet to get a broad view of the health of a company.
The primary way investment bankers pull apart the financial statements is by using financial ratios (see Chapter 8). But there are ways to glean insights into a company’s financial health just using the balance sheet, which we discuss in the next few sections.
One of the key weapons of investment bankers is the technique of common sizing, a type of financial analysis that measures all the elements of a financial statement relative to the total. When common sizing the balance sheet, all the company’s individual assets are divided by the total assets and each of the individual liabilities are divided by the total assets, too.
This seemingly simple exercise can quickly put a company’s balance sheet into perspective. Table 7-1 is a simple example of common size analysis using Hershey’s 2018 balance sheet. Notice how the common sizing puts the numbers in context.
An investment banker would look at this common size analysis, and several things would immediately jump out. First, notice that nearly 8 percent of the company’s total assets are held in cash. An investment banker may wonder if there might be better uses for that cash than sitting idly collecting interest. Another takeaway is that 60 percent of the company’s assets are tied up in property, plant, and equipment. This indicates that the company is pretty capital intensive, meaning large investments in equipment are needed to compete.
TABLE 7-1 Putting Hershey’s Balance Sheet into Perspective
Balance Sheet Line Item |
2018 Value ($ millions) |
Common sized Value |
Cash and equivalents |
$588 |
7.6% |
Accounts receivable |
$594 |
7.7% |
Inventories |
$785 |
10.2% |
Property, plant, and equipment |
$4,582 |
59.5% |
Goodwill |
$1,801 |
23.4% |
Other assets |
$127 |
1.6% |
Total assets |
$7,703 |
100% |
Accounts payable |
$502 |
6.5% |
Short-term debt |
$1,198 |
15.6% |
Current portion of long-term debt |
$5.4 |
0.07% |
Long-term debt |
$3,254 |
42.2% |
Other liabilities |
$185 |
2.4% |
Total liabilities |
$6,296 |
81.7% |
Total equity |
$1,399 |
18.2% |
One of the most telling exercises for investment bankers looking at the balance sheet is the relationship between a company’s total debt and its equity. By simply dividing a company’s total liabilities by its total equity, investment bankers can see how leveraged a company is, or how much of the cost of the company’s assets are financed using debt and how much are financed using equity.
Using the preceding Hershey example, investment bankers see that the company relies much more heavily — more than three times more — on borrowings than on equity. Knowing this will help guide the investment bankers offering solutions to the company.
A company’s book value of equity, loosely speaking, is much like a person’s net worth. The book value of equity of a company is a rough estimate of what the company’s collection of assets is worth after paying all its liabilities. The key assumption, here, however, is that assets are liquidated at book value and liabilities are extinguished at book value. In reality, some assets, such as land, may be worth much more than book value, and other assets, such as inventory, may be worth much less than book value. Book value of equity is calculated by subtracting total liabilities and goodwill from a company’s total assets.
When individuals meet a financial planner, one of the first things they do is create a net worth statement. The net worth statement outlines all the assets owned and all the liabilities owed by the individual. At just a glance, the financial planner can create a set of priorities for the person to achieve. Similarly, an investment banker can get a quick opinion on a company’s opportunities and deficiencies by looking at the balance sheet, including
Opportunity to increase leverage: One of the top tricks of investment banks is helping companies sell debt securities to increase their level of leverage. By deploying more debt, depending on where interest rates are, companies can push their profitability up and appease and please stockholders. When a company uses debt to boost profit, that in turn increases the return on equity invested in the business.
Increased debt can work both ways for a company. Investors may be pleased by the increased returns by using debt, but the change also increases risk. Greater leverage can be dangerous if a company’s cash flow falls and the interest payments turn onerous. That’s why leverage is often referred to as a “double-edged sword.”
Most individual investors dwell on the income statement and, to a lesser degree, the balance sheet. Investors are keenly tuned into how much a company is earning (so they can look for potential stock price growth) and how much cash a company has (eyeing fat dividends).
But investment bankers know the power of a third, often overlooked financial statement: the statement of cash flows. The statement of cash flows is the place where the company tells investors where the dollars are coming and going in the business.
Cash is king in investment banking. Make no mistake about it: The ability of a company to take on more debt or even do a deal often hinges on the business’s cash generation characteristics. Companies with large and stable cash flows are often candidates for investment banking techniques, as the manager of the business attempts to extract greater profit from the company using financial tools.
And keep in mind that although the income statement is important in investment banking analysis, it’s largely a tool designed by accountants. Net income is generated when companies follow a set of rules that accountants say determines the profitability of a firm. The statement of cash flows, on the other hand, is much less subjective. When a company hauls in or spends a dollar, there’s no questioning it. A dollar is a dollar. You can spend dollars — you can’t spend profits!
Follow the money! That’s the advice often given to detectives and investigators. And the same can be said to investment bankers. Tracing the movement of cash through a company can tell the investment banker a great deal about the company and its economic feasibility. The cash flow statement is a powerful document that shows investment bankers how the business is a cash-using (or cash-burning) machine. This section gives investment bankers a quick run through the parts of the cash flow worth paying the most attention to.
The statement of cash flows is broken into three distinct areas. Each areas reveals specific information about the type of cash flow.
If you want to know how much cash it brought from the business itself, this section is the one for you. Here, you find how much of the company’s profit came from conducting business in cash.
Calculating cash flows provided from operating activities starts with net income, taken right from the income statement. Uses of cash are then deducted from net income, and sources of cash are added back. The most important adjustments to cash flow in the eyes of investment bankers include
You have to use cash to make cash. Companies can often borrow money to make improvements to their facilities, but many times a company taps its cash hoard to add capacity, expand facilities, or build new computer systems.
The starting point for calculating cash flows provided from investing activities is cash flows provided from operating activities (from the preceding section). From there, a number of adjustments are made to show investors how much cash is used or generated not just from the company’s operations, but also its investments. Sources of cash are added back, while uses of cash are subtracted, as follows:
Even the simplest companies typically use cash that’s brought in from outside investors or lenders. Even a 5-year-old opening her first lemonade stand likely got started using a loan to buy lemons and sugar from her parents.
This section of the cash flow statement attempts to help investors see the inputs and outflows of different forms of financing, be it from debt or stock. Digging into this area of the cash flow statement gives investment bankers a clear view of where the company is getting and using cash to pay for its operations. This section includes the following:
Increases in debt: When companies borrow, it’s an addition to cash from financing and added to cash flow. Investment bankers can keep an eye on whether companies have been adding to debt if they see increases on this line item in the statement of cash flows.
Companies often distinguish when they add short-term versus long-term debt. Often, when companies restructure, they try to exchange costly debt that matures in a few years, called short-term debt, with longer-term debt that matures in five or more years. This common maneuver, which often taps the resources of investment bankers, is designed to save on current interest expense.
As you can see, the statement of cash flow is a very comprehensive financial statement. Literally, every dollar flowing in and out of the company is counted and classified into the proper category.
But investment bankers often mix and match items from the three sections of the cash flow statement to get numbers that are most telling for them. One of the best examples of this kind of adjustment is free cash flow (FCF ). Free cash flow measures the company’s cash flow power from its core operations, after making the necessary improvements to its assets to keep the business running smoothly. Remember: A company that doesn’t invest in keeping up its plant and equipment isn’t going to be in business for the long-term.
Start with net cash flows provided from operating activities.
On the statement of cash flows, the last item in the section, cash flows provided from operating activities is net cash flows from operating activities. This number is net income adjusted for all the uses and sources of cash from the company’s normal operations.
Subtract capital additions from net cash from operating activities.
You’ll find capital additions from the cash flows provided by investing activities section of the cash flow statement.
Analyze the findings.
The free cash flow number gives investment bankers a good look at how much cash the company needs to keep running on an ongoing basis. It’s a good idea to do the same calculation for past periods, too, to see if the company’s cash flow usage is rising or falling over time.
The three primary financial statements are the income statement, balance sheet, and the statement of cash flows. These three documents, when looked at together, give investment bankers an excellent view of the profitability, financial resources, and cash-generating characteristics of any firm.
But there’s another document, which isn’t technically a financial statement, that’s very valuable to investment bankers as well. This document, called the proxy statement (sometimes known by its formal name, DEF 14A), is a bonanza for anyone looking to learn more about the company.
There’s much more to the proxy statement than we have room for in this section. Our goal here is to help you identify the parts of the document of most interest to investment banking.
Real-estate brokers know that the biggest part of doing a real-estate deal is getting to know the people involved. It’s exactly the same when looking to broker deals with companies. Personalities, egos, and relationships play a huge part in just about every deal investment bankers do, including helping along mergers, divestitures, and IPOs.
Because personalities are so important, investment bankers must take the time to get to know the people running the company. An excellent place to get started is the proxy statement, which spells out details about the people of power in a company.
A few of the details about people in a deal you can uncover from the proxy include
The biggest reason for diving in to the proxy statement and looking at the way the executives are paid isn’t to get paycheck envy (although that may be a side-effect of doing so — during 2018, for instance, the median total compensation paid to CEOs of companies in the largest 500 companies by revenue was $12 million, up 25 percent from 2013, according to an Equilar analysis). The reason investment bankers pay such close attention to the way CEOs are paid is to understand what makes them tick, financially.
For instance, an empirical look at the financial statements may make a great case for divesting a business unit. The business may be a total loser, generating low returns relative to the enormous investments needed to keep the business humming. A sale may bring cash into the company that could be paid as a dividend or plowed into another area of the business that’s more profitable.
But an examination of the CEO’s pay structure may explain why there’s resistance to the deal. For instance, if the CEO’s bonus is based in part on the company’s total revenue hitting a certain size, a divestiture would likely reduce revenue and, in turn, reduce the CEO’s bonus.
It’s important to understand that the management of companies are hired hands. The CEO and the rest of the management team are employed by the shareholders of the company to run it in the best way to generate returns for the stakeholders. But the CEO isn’t running the company for fun — he expects to get paid (and paid handsomely) for his time and effort.
Before an investment banker even thinks about approaching a CEO to discuss a deal, it’s imperative to understand the size and nature of the CEO’s pay. And that’s very possible using the proxy.
You can spend quite a bit of time analyzing the proxy, looking for all the ways the management is paid. The best way to see, quickly, how much CEOs are paid is to head to the summary compensation table in the proxy statement. The key portions of a manager’s pay breaks down as follows:
3.80.4.147