“Ultimately, the balance sheet, income statement, and cash flow statement work together to explain the performance of a company. None of the statements is independent of the others.”

The other side of the balance sheet is made up of liabilities and shareholders’ equity. You can think about this as the way the company funds itself.

In the case of a leveraged buyout, the right side of a balance sheet would typically see a large shift in the amount of debt relative to equity. The assets of the company would not necessarily change immediately after a leveraged buyout, as the transaction is primarily a matter of the company’s capital structure. The cash that the company generates via its business activities in the future can be used to pay down debt and increase shareholders’ equity through retained earnings.

“With leveraged buyouts, we are particularly concerned with the cash flow available to pay down debt.”

“Ideally, a company will have strong and stable revenues (which will lead to strong, steady cash flow). Opportunities for cost reductions within its operations are also prized.”

The growth and value of any company begins with revenue. If revenue begins to decrease, a company has little choice but to look for areas to cut costs. However, costs can only be reduced to a certain point. For this reason, analysts will pay close attention to the revenue of any potential buyout target. Ideally, a company will have strong and stable revenues (which will lead to strong, steady cash flow). Additionally, it is also looked on favorably when a potential buyout company has opportunities for cost reductions within its operations. Investors and business managers see this as a proven way to increase the profitability of a company that can later turn into handsome returns for investors upon the sale of the company.

The righthand, or liability, side of the balance sheet is particularly important in a leveraged buyout, because the analyst needs to assess potential capital structures and make a determination as to whether the target company can withstand the financial pressures that go along with a leveraged buyout. The interest expense that accompanies the debt is calculated from the beginning debt balance of each period and appears in the income statement as interest expense. In times of profitability excess cash is used to pay down the outstanding principal on the debt. This in turn works to reduce the interest expense due each following period.

In short, the balance sheet records the levels of debt the company keeps on its books, which translates into the interest expense that embodies the financial burden of a leveraged buyout.

“In the case of the cash flow statement, the numbers don’t lie – or at least they shouldn’t.”

(Note: The practice of reflecting assets on the balance sheet at prices that represent what the assets could be sold for on the open market is referred to as marking to market.)

Fortunately, in the case of the cash flow statement, the numbers don’t lie – or at least they shouldn’t lie. The cash flow statement is used to determine the actual amount of cash that came into or flowed out of the company. It should strip out any non-cash expenses such as depreciation and amortization and include things like cash spent on capital expenditures or changes in net working capital. This way it will provide a genuine reflection of any increase or decrease in cash.

The cash flow statement is extremely important in the case of a leveraged buyout analysis because it is cash that is used to make interest payments and pay down principal on existing debt. Cash flow from the company’s operations, as described above, is forecasted out along with the other financial statements to determine the amount of cash flow available each period to pay down debt. The cash flow and ability of the company to pay down debt is at the heart of the leveraged buyout analysis and cannot be overemphasized.

The debt sweep is used in conjunction with the cash flow statement to determine and project the amount of leverage the company retains on its balance sheet in the future. As we pointed out for the cash flow statement, cash available to pay down existing debt is calculated based on net income after adding back non-cash charges and adjusting for considerations such as capital expenditures and changes in net working capital. The resulting number is used within the debt sweep to determine to what degree existing leverage can be paid down or in the case of a negative result, the additional cash the company must borrow to fund its operations.

The debt sweep is where all calculations regarding changes in leverage occur. It is the epicenter of all reduction or raising of debt on the company’s balance sheet and is inseparable from the cash flow statement. The resulting calculations in the debt sweep will have a direct impact on the interest expense of the following period. The more cash generated, the more debt can be paid down. The more debt can be paid down, the lower the interest expense that will be charged at the end of the period. The debt sweep captures the movement of debt on the balance sheet and plays a critical role in calculating the levels of debt on which interest may be charged for upcoming periods.

Ratios should be used and analyzed within in the context of the financial statements and other ratios. On a standalone basis, one ratio seldom provides a significant amount of insight on a particular company. However, when viewed within the context of a company’s financial statements and performance in terms of absolute dollars (or pounds, or euros), ratios can provide meaningful insight into the workings and performance of a company, particularly when comparing across firms with varying scales of operation.

The simple answer is that the goal of the analysis is to forecast the returns of the investment. However, there are several other aspects of the potential transaction that an investor will be interested in knowing about before making the decision to invest. In general, a potential investor will want to know more about the path that is being taken on the way to the projected return on investment.

In order to determine how much a transaction is going to cost, our starting point is the company’s current stock price. On top of a current stock price a premium is often added to sweeten the deal and convince the current shareholders to sell. The result is the offered acquisition price. Multiply the offered price by the number of shares outstanding and you have the total cost of the acquired equity. On top of the cost of the acquired equity there will be transaction costs for bankers, lawyers and the like that will require payment as well. Finally, any existing net debt, which is made up of interest-bearing debt less cash on the balance sheet, will often times be refinanced and hence require cash to be paid down. All in all, the total use of funds (or cash required to close the transaction) will be the sum of the acquisition equity, associated transaction costs, and net debt that is refinanced:

cash to close the deal = acquisition equity + associated transaction costs + net debt refinanced

With the price tag for the transaction fully established we need to determine where the money is going to come from to pay for the transaction. In the end, the investor has to make a decision as to how much equity will be put up in the buyout. This is often influenced by a sensitivity analysis on various financing options and how much creditors are willing to lend. In many cases the equity partners are willing to take as much leverage as they can get from creditors and risk as little of their own capital as possible. Once the equity investment amount is determined, the debt financing will account for the balance of the required funds for the transaction. Note that there can be more than one debt instrument used to finance a leveraged buyout and each separate type of debt financing will charge its own interest rate based on several factors, including seniority in the credit structure.

“Past performance is used to estimate what revenue growth and cost structures will look like in the future.”

Similar to revenue, most costs estimates are formulated and heavily based on the previous performance of the company. There are several methods for estimating pro forma costs. One common method is forecasting costs as a percentage of revenue. This method increases costs in direct proportion to the growth of the business and its revenues. This method works well with items such as cost of goods sold and to some extent selling, general and administrative, although some may prefer another method. Some costs such as depreciation and amortization can be determined by using more complex methods and amortization schedules. (More complex treatment of depreciation and amortization is beyond the scope of this book, so for the purposes of focusing on leveraged buyout analysis we assume in our example that depreciation and amortization grow as a percentage of revenue as well.)

“There are several methods for estimating pro forma costs. One common method is forecasting costs as a percentage of revenue.”

Prior year interest expense can be ignored because it is not a concern when formulating a pro forma income statement, as we will be calculating interest expense based on a new capital structure with a separate interest rate. However, interest income and interest expense cannot be calculated until pro forma cash flow and debt paydown have been estimated. This means that the interest portion of the income statement must be revisited later in the creation phase of the analysis in order to be completed.

Frequently in a leveraged buyout analysis it is assumed that the entire amount of cash flow available for the repayment of debt is used for that purpose when the amount of debt is greater than the available cash flow figure. Under circumstances where the period’s available cash flow amount is greater than the existing debt on the company’s balance sheet the excess cash is presumed to be added to the ending cash balance on the balance sheet. In other words the cash balance of the company increases when the cash flow available for debt repayment is larger than the existing debt on the company’s balance sheet.

Both the interest expense and interest income the company recognizes in its income statement are calculated based on the debt and cash calculations that result from the debt sweep. This is the heart of the leveraged buyout. The success of the company depends on its ability to pay down its debt. This determines whether or not a transaction can emerge as a profitable endeavor for the investors or result in the company drowning in its own debt.

In addition to the internal rate of return, it is common to calculate the implied multiple of money for an investment. Divide implied equity value by the initial equity investment amount to arrive at the multiple value for each period. Unlike the IRR calculation, the implied multiple of money does not take into consideration the time value of money. However, the implied multiple of money does deal in terms of absolute dollars, which makes it easy to quickly grasp how much money the investor expects to realize in returns.

“Ratios and statistics help us measure a company’s financial health and compare different companies on a relative basis.”

Some statistics that would be of interest in a leveraged buyout analysis focus on the capital structure and credit ratios of the company. This may include ratios such as, debt to equity, debt to capital, EBITDA to interest, EBIT to interest, debt to EBITDA, and net debt to EBITDA to name a few. Ratios should be calculated for all periods within the explicit forecast range. When completed, the ratios should help in identifying any trends or patterns occurring within the company.