An Introduction to Income Statement Modeling

Private Equity Primer's Deal Sherpas developed the following overivew on the basics of income statement modeling for a group of college interns working for Splash 4 Partners.  The interns had limited to no-exposure to financial modeling and were tasked with rapidly evaluating the growth prospects of a publically traded company. This was the first part in a larger training that built up to evaluating the buyout value of a division of the assigned company.  The company evaluated was a client of Splash 4 Partners exploring its strategic options.

Please enjoy and share the desktop reference for income statement modeling.   

Income Statement Modeling

Accurate financial modeling is all about fundamentals. As a result, some of this might look pretty basic. However, thinking through the drivers of a business and mapping out what is to be calculated and measured saves you time when you are building and manipulating the model. 

In other words, ask yourself what are the major key performance indicators for the company.  Having this vision of what is important is critical in analyzing a business systematically and by the numbers.

To peer into the future of a company, you have to understand where it is today.  This is why you need to start by looking at historic financials.

When you look at a business, regardless of sector, identify what the fundamental revenue and cost drivers of the business are.  Don’t get overly hung up on the name of the business model that the examined company can be categorized.  Understand the drivers of how the company makes and loses money first.  The financials are nothing more than a numerical picture of the strategies, decisions, execution, transactions and operations of a business.

The concept of business models is helpful only in so far that a brick and mortar retail company, a software-as-a-service business, or direct marketing business all possess core drivers that are present in other brick and mortar retail, software-as-a-service, and direct marketing companies. 

When examining a company ask yourself two question:

This looks like basic accounting.  Remember it’s about the fundamentals.

As you go through this exercise, your objective is to understand the company’s profitability and what levers (aka: drivers, variables) can be pulled to meaningfully impact said profitability.

When modeling for earnings (profit/loss), as an equity researcher would when looking at a public company, you are not just trying to get to that quarter’s or year’s one time profit/ loss.  Rather your goal is to understand the basis of their recurring operations.  Meaning you want to calculate the normalized earnings.  By gaining a clear picture of the recurring revenue and expenses, you then have the ability to start to gaze into the future and forecast.

Note: This is income statement focused.  In some businesses GAAP or accounting profit can deviate substantially from cash profit or cash flow generated in a period.  While the focus here is on forecasting accounting profit, later we will deal with forecasting cash flow.

On a historic basis, the EPS calculation is simple as there is no guessing.  You have the historic figures to get you the actual number.  When forecasting future years, you have to gross up or down the shares outstanding due to share buyback programs, secondary offerings, and options being executed.

To Infinity & Beyond

Forecasting the future is hard.  The future rarely maps one for one into columns, rows, numbers, and our predefined categories.  Many forecasters say that the one thing you know about a model when it is finished is that it is not right.

This is why you are not looking for it to be on the nose, but rather to be as precise as possible.  You will be forced to simplify things.  If you have done academic style discounted cash flow modeling, you likely have used simplifying assumptions with an indefinite time horizon.  This calls for flat lining many drivers and inputs into perpetuity.  We know that prices and volume are rarely constant over time, making this type of modeling rather imprecise and little more than directionally helpful.

What you see with most models in equity research and investment banking is forecasting between three and five years out.  Generally speaking (though highly dependent on the business and situation), your one year numbers are going to be closest to reality.  Years two and three will decouple some from reality, and years four and five are more about being in the ball park (likely in the cheap seats far from the action).  The further out the forecast moves, your conviction behind being accurate should decrease.

Revenue Modeling

How does a company make money?  Understanding the answer to this is to understand the basis of the company itself—its point for existing in the first place.  Many companies have multiple revenue streams.  Take lululemon for instance, they sell through:

1.       Brick and mortar retail

2.       Online

3.       Third party yoga studios

In short, they have three ways or channels of reaching their customers. 

Similarly, many software-as-a-service companies have multiple revenue streams.  The subscription fees often being the primary line of revenue and consulting & training being a secondary income stream.

For the purpose of illustration, we will keep with the lululemon example.  Each revenue stream can be broken down to its elements.  I will focus on their brick and mortar operations below.  Keep in mind that if you understand what revenue source is generating the greatest increase or decrease to revenue, you can then compare that to the actions of management and their investment in time, labor, and capital to assess growth strategies and probability to profitable execution.

Brick and Mortar Retail

What are the components of this revenue stream?

 

Clearly, each of these variables listed can be broken down more and more.  For instance, if lululemon followed the model of other retailers and had many types of stores (e.g. boutique urban vs. large suburban) getting to an accurate forecast would mean understanding how these stores differ not only by square footage but also by the inventory each stocks. 

Access to data will often drive the granularity and precision in which you can model.  For instance, same store sales is the figure often calculated by the company.  Many companies change the basis of months to fit their definition of what a “mature store” or store that reaches its normalized sales basis.  Without access to the raw data you are at the mercy of the data supplier.

This is why you need to contemplate other accurate ways to calculate revenue.

 

What will change the revenue projections for this income stream is sales volume and the amount of retail space. Clearly there are drivers behind each of these variables.  If you can get to sales volumes and the retail space controlled, then you can get to a brick and mortar’s projected revenue streams.

Modeling Expenses

How does a company spend money?  This is driving at cost centers.  Break out expenses into fixed versus variable.  Most direct costs, COGS, and costs of production tend to be variable; while operating expenses or indirect expenses tend to be more fixed.  Rent, for instance, is usually a fixed cost.  Variable would be the number of employees needed in a factory based on production demand.  The higher percentage of fixed expenses a business has, the less play and flexibility it has in managing its cost structure to profitability during a downturn.

The simple and less robust way of modeling expenses is taking the average of the last three years (good for mature, steady, and flat growth companies, not very accurate for high growth companies) and gross up or down based on projected demand and investment.  This technique is generally ill advised if better information is available.

One can get far more granular by moving to the balance sheet and modeling specific working capital requirements in relation to projected revenue levels.  

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