14 Oct How an Appraiser Analyzes Income Statements

Written By: Mia Carley

(4-6 minute read)

During the initial financial statement review portion of the business valuation process, an appraiser will review the subject company’s financial statements for the analyzed period. A few important areas of a company’s income statement that are analyzed include sales, Cost of Goods Sold (COGS), officer compensation, and other deductions/operating expenses. It is important for an appraiser to understand how the company’s sales and expenses are reported over the analyzed period to accurately assess year-over-year fluctuations and margins, or to make the appropriate cash flow adjustments.

Sales:

The appraiser will utilize the initial sales portion of the company’s income statements to compare the sales figures throughout the analyzed period and identify any year-over-year fluctuations, for which the appraiser may request explanation. Typically, an appraiser will ask about any sales fluctuations over historical years, as well as interim annualized and/or projected sales fluctuation compared to the most recent full year (if the interim period is less than 12 months). For more information on year-over-year financial analysis, please visit: https://reliantvalue.com/analyzing-financials-on-a-year-by-year-basis/

An appraiser will also analyze total reported sales to determine if non-recurring or non-operating income has been recorded (for more information on other income, please visit: https://reliantvalue.com/identifying-adjusting-other-income/), as well as if total reported sales include pass-through items such as sales tax or tips income. Sales taxes and tips are considered pass-through income offset dollar for dollar by expenses and are not typically recorded on financial statements. If they have been recorded, to avoid overstating both revenues and expenses and to properly analyze operating margins, the offsetting income and expense amounts will be removed (causing no net change to earnings).

Cost of Goods Sold (COGS):

Depending on the industry, the next component that an appraiser will analyze within an income statement is cost of goods sold (COGS). It should be noted that an appraiser will assess year-over-year fluctuations in COGS (notably, purchases and cost of labor) as a margin of sales due to the variable nature of these costs. For example, consider the following company sales and COGS across an analyzed period:

Despite COGS fluctuating as a dollar amount year-over-year, the COGS percentage is between 48% – 52.1% of sales in each year, which an appraiser would deem reasonable, and no further questions would be required.

Additionally, it should be noted that COGS usually will include beginning and ending inventory, purchases, and cost of labor. However, businesses can also classify business operating expenses within COGS if they believe it is tied to the completion of its services / products. Therefore, it is important to analyze COGS on a line by line basis to assess non-recurring or non-operating expenses, as well as classification issues across the analyzed period.

For example, consider the following company breakdown of COGS and labor:

At first glance it would appear the company did not report Salaries and Wages through the interim period, and this would need to be further analyzed by the appraiser. However, when considering the total labor costs as a percentage of sales, it is evident that the interim internally prepared financials classified the expenses differently than the year-end federal tax returns, and, therefore, no further analysis is required. The appraiser can reclassify all labor related costs to a single line item or make note of this within the appraisal. This methodology is aligned with how an appraiser would handle other expenses (such as auto, insurance, utilities, rent, depreciation, etc.) if they were classified as operating expenses historically but were recorded within COGS in the interim period (or vice versa).

Officer Compensation:

Another key component of income statement analysis is determining whether the owner of the company receives compensation through the company’s labor expenses (salaries and wages, cost of labor (within COGS), etc.). The appraiser will add the actual compensation back to the company’s net income and will remove a fair-market replacement salary to calculate EBITDA; the appraiser will then add the fair-market salary back to calculate the seller’s discretionary earnings stream (SDE); i.e., the true cash flow to the owner.

Officer Compensation or Guaranteed Payments to Partners will typically be identified on federal tax returns. However, if tax returns are not available or do not identify officer compensation, the appraiser should ask if the owners are receiving pay from the company. If so, documentation will be requested in the form of W2s or paystubs / wage statements to support the salary amount in each year. If documentation cannot be provided, the appraiser will be unable to verify the compensation, therefore, will not be able to add the expense back to net income, which may impact the company’s earnings and the final value.

Other Deductions/Operating Expenses:

If the financials provided include tax returns, an appraiser must confirm that Other Deductions (typically a statement included within the tax returns) are broken out by each expense. When analyzing other deductions and operating expenses an appraiser must focus on a few different factors: variable expenses, fixed expenses, non-recurring expenses, or non-operating expenses.

• Variable expenses: A variable expense will fluctuate in direct proportion to production or sales volume. Examples include production labor, shipping and freight, transaction and payment fees, equipment maintenance, etc. These expenses should be analyzed on a margin of sales basis. For example, if a company’s sales increase by 10%, it is likely that production labor and transaction and payment fees would increase by a similar amount, and still reflect a similar margin of sales.
• Fixed expenses:A fixed expense is a predictable cost that will remain the same regardless of the company’s sales volume over a given period. Examples include rent, administrative salaries, insurance premiums, and software subscriptions. These expenses should be analyzed on a dollar-for-dollar basis. For example, if a company is stated to lease its facility, regardless of sales, the rent should remain similar (or increase based on negotiated lease rates). If the rent increases or decreases significantly, it should be questioned as to why.

In addition to analyzing the major expenses based on the above criteria, an appraiser should also review all statements included within the federal tax returns, as well as each expense reported within internally prepared, or CPA compiled, reviewed, or audited statements. Certain expenses may be clearly labeled as non-operating, or non-recurring, such as income taxes, owner’s health insurance, owner’s benefits, etc. If a company reports certain expenses which may be considered discretionary in nature based on the type of business, an appraiser may request the appropriate documentation (e.g., general ledgers, check copies, billing statements, etc.) to reclassify/break out these expenses and make the appropriate cash flow adjustment(s). For more information on financial statement adjustments, please visit: https://reliantvalue.com/financial-statement-adjustments/ and https://reliantvalue.com/financial-statement-adjustments-part-2/.

As discussed, income statement analysis is a key component of the overall business valuation process; in particular, as it presents the appraiser with an opportunity to identify and request explanation regarding sales and expense fluctuation and classification differences within the analyzed period. This analysis will ultimately lead to the appraiser making the appropriate cash flow adjustments, applying the proper weighting to historical periods, and calculating the most accurate opinion of value.