Developing a Basic Financial Model – Part I: The Income Statement

Excel is probably the most popular spreadsheet in use today, and certainly a mainstay of investment banks, private equity firms and hedge funds. It offers a tremendous amount of flexibility to develop a wide array of financial computations, ranging from simple, static calculations to complex, dynamic analyses. In order to effectively develop financial models for use in valuation analyses or forecasting, it is important to understand how companies show their information. This article is an overview of the link between the basic components of a full financial spreadsheet: income statement, balance sheet and cash flow. Because these financial statements are based on accounting rules, there will be some accounting theory used in this article but only very high level, basic elements to allow the reader to follow along.

The Income Statement

The income statement includes items that give an indication of how much a company sells (called revenue, sales or net sales) and what it costs to run the business (cost of sales, operating expenses, taxes). If you took sales and subtracted all of the expenses, what is left is the net income of a company. An example income statement will look like the following:

Net Sales
- Cost of Sales
= Gross Profit

- Operating Expenses
= Operating Profit

- Interest Expense
+ Interest Income
+/- Other Expense/Income
= Pretax Income

- Income Taxes
= Net Income

Net sales represents what a company has sold, whether a physical product (box, toy, car, etc.) or a service. The cost of sales represents what expenses a company incurred to provide the physical product or service. For example, if a company sold $100 worth of shoes and the machine usage to make those shoes was $40, than $40 is your cost of sales, and thus, the gross profit is $60. In general, a manufacturing business has costs related to the running of machinery to make a product plus a depreciation value associated with the economic wear and tear, which is usually included in cost of sales.

Operating expenses relate to items including the administrative parts of running a business, including payroll, rent or lease payments, advertising and marketing, depreciation and amortization on office fixtures and other general and administrative items. This category is usually reserved for the non-activity aspects of business. Some companies, like pharmaceutical or electronics entities, will also have research and development expenses, and these are normally listed under this section of the income statement. After summing all of these expenses and subtracting from gross profit, you are left with operating income (or operating loss).

Operating income is an important figure in business because that is what a company generates before any financing decisions are taken into account. This number is also referred to as EBIT (earnings before interest and taxes), and when you add back all depreciation, amortization and other "non-cash" charges, you arrive at EBITDA (earnings before interest, taxes, depreciation and amortization). EBITDA is and important calculation in the financial analysis world because it represents the cash income earned for running a business. This is the figure used in many industries to determine valuation, as well as how much debt a company can handle.

After operating income, you will include items involved in the financing of a company, like interest expense for a company who has debt. In addition, you would include interest earned from excess cash balances or short-term and long-term investments. If the company is a financial institution, this interest expense and interest income lines are actually part of revenue and cost of revenue, so you would see that information near the top, but for most other industries, it constitutes a place below operating income. Finally, if there are any other non-operating sources of income, like gains on sales of assets, it would be included in this area, too. The sum of all of these entries is normally called "Other Expenses, Net."

Once the other expenses are subtracted from operating income, a company has pretax income, or income before income tax provision. This is the accounting figure used to determine how much tax an entity is required to pay to the government. Normally, companies pay around a 35% federal income tax, and they may have to pay a state and local tax amount based on specific tax rules. There are also other items that impact how much tax must be paid, including any operating losses from a prior year, tax credits used to offset taxable income, and certain accounting methods that can increase or decrease the amounts owed during a particular time period. Once the total tax is determined, the net income can then be calculated.

Without getting too much into accounting methods and tax law, the net income number is merely the result of accounting methodologies and does not necessarily reflect the cash generation of the firm. As stated earlier, EBITDA is a better metric of a company's ability to generate cash. As will be discussed later, there are certain items to be deducted from EBITDA to determine true free cash flow, but for now, just note that cash generation and accounting regulations create a different set of results. It is important to keep that in mind when you develop your financial models because understanding the components of the income statement is the first step in putting it all together.