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Breaking Into Wall Street - The 3 Financial Statements

($ in Thousands)
Concept: Rather than using all of our excess cash to pay dividends to investors, or to repurchase
ACQUIRE SOME SMALLER COMPANIES! (And gain useful assets in the process)

Why do this? Acquisitions are just another way that companies can spend their excess cash each
share repurchases, more CapEx, more operating expenses (hiring people), buying investments, an

If you think another company has an asset, or a team, or a customer base, or something else valua
it might make sense to acquire that other company.

Put simply: if you think the price you pay for the company is less than its future value (NPV of cash
do the deal although a lot of deals are done for far less rational reasons than this (ego, politics, d
Our Scenario - INTRODUCTION to Accounting for Mergers & Acquisitions:

This is JUST an introduction to the basics so you understand how items like Goodwill and Other Int
we go into it in a lot more detail in the Merger Module modules (it gets complicated, and we don't

We find a promising young start-up company with no revenue or expenses yet - it's really just 1
he has developed. Might be a new training method for learning financial modeling, software for lea

Here's what its Balance Sheet looks like (Income Statement and Cash Flow Statement are irrelevan
Balance Sheet:
Assets:
Current Assets:
Cash:
Total Current Assets:

Year 1

Long-Term Assets:
Property, Plant & Equipment:
Total Long-Term Assets:

How is This Possible?

100
100

30
30

Easy: the Founder started it


initially went into Cash on t
other side

Then spent $30K of it on bu


computers or other electron
for other purchases he's ma

So what happens when


Total Assets:
Liabilities & Equity:
Current Liabilities:
Accounts Payable:
Total Current Liabilities:
Long-Term Liabilities:
Debt:

130

First off: He's not going to s


something like that. After al
more in Assets!
$

30
30

He wants some type of


up with our team.

For established companies,

Total Long-Term Liabilities:

Equity:
Total Liabilities & Equity:

operating income, net incom


those but with a start-up

100
$

We offer him
about 2x his invested capita

130

So What Happens Next After We Offer Him the $250K for His Business?
There's no Income Statement or Cash Flow Statement to worry about (yet), so we just

So, we literally ADD his company's Assets and Liabilities to our own but there's one small p

According to accounting rules, we do NOT just add his Equity to our Balance Sheet. Remembe
to THAT old company that no longer exists!

When we acquire it, the cash we pay for the company represents its "new value", and we WIPE
company is no longer an independent entity.

BUT that creates a big problem in the model. Take a look at this hypothetical combination in
Balance Sheets @ Year 2 End:
Assets:
Total Current Assets:

BIWS

Goodwill:
Other Intangible Assets:
Total Long-Term Assets:
Total Assets:
Liabilities & Equity:
Total Current Liabilities:

Other Co.

531

310

100
30

841

130

60

30

Total Long-Term Liabilities:

290

Equity:

491

100

Total Liabilities & Equity:


BALANCE CHECK:

841
OK!

130
OK!

So we will almost always run into this issue of the combined Balance Sheet not balancing when w
something DIFFERENT from the value of its Equity on the Balance Sheet.
IF we paid only $100K for the company, we wouldn't have this issue but would the owner really

We need something to "plug the gap" when the Purchase Price exceeds the Equity of the acquired
even when we use debt to buy it, or issue stock to buy it, or anything else).
That "something" is called Goodwill and Other Intangible Assets. Here's how it works

First, you check to see if the company has any "Other Intangible Assets" that might be worth som

Examples: Patents, trademarks, intellectual property, contracts, customer/vendor relationships, b


Definition: Anything that's NOT a physical asset you can touch, and also NOT

So let's say we look at Other Co's new, snazzy intellectual property, and decide it's worth $50K to u
in future cash flows it could add to our business. Nothing else substantial yet, so that's about it for
We create a new line item called Other Intangible Assets (sometimes just Intangible Assets
Purchase Price Allocation:
Purchase Price:

Year 2

Here's what our allocation o


like so far, with these Other

250

Write-Off of Seller's Equity:


Other Intangible Assets:
Total Allocation:

100 <---------------------Always write this off whe


50 <---------------------Represents our best esti
150 <---------------------Not bad! Getting closer.

"The Gap":

100

But we're still not there. How can we "plug" this remaining $100K gap?

We create another new asset called Goodwill, which represents the premium paid above comp
and the premium above other adjustments we've made, including these "Other Intangible Asset
Purchase Price Allocation:
Purchase Price:

Year 2

Here's the "Finished" purcha

250

Write-Off of Seller's Equity:


Other Intangible Assets:
Goodwill:
Total Allocation:

100
50
100
250

"The Gap":

- <---------------------Boom, we're done! Ever

What's the difference between Goodwill and Other Intangible Assets?

Both are created only in the course of acquisitions (not exactly true under IFRS), but they represen

Other Intangible Assets: Correspond to identifiable assets, such as contracts, patents, tradem

name and explain why it's worth something.

These also get amortized over time, just like how PP&E gets depreciated. Same idea: allocate t
on the Income Statement reflects how these assets also "decline in value" over time.

Goodwill: Corresponds to assets that cannot be readily identified on the seller's Balance Sheet "
premium you pay over the company's Balance Sheet value.

Under US GAAP and IFRS, Goodwill is not amortized and simply stays on the Balance Sheet unless

Ninja Tip: This is not true under all accounting systems worldwide - you'll see an example later in
Example in Our 3-Statement Model:
Tax Rate:

40.0%

Inventory Purchases (Year 2):


Deferred Revenue Additions (Year 2):
Accounts Payable Additions (Year 2):
Prepaid Expense Additions (Year 2):
Accounts Receivable Additions (Year 2):

$
$
$
$
$

30
15
15
30
50

Deferred Income Taxes (Year 2):


Stock-Based Compensation (Year 2):

$
$

50
20

Income Statement:
Revenue:
Cost of Goods Sold (COGS):
Gross Profit:
Gross Margin %:
Operating Expenses:
Sales & Marketing:
Research & Development:

Year 1
$

650 $
70
580
89.2%

150
75

Year 2
700
70
630
90.0%

165
75

Capital Expenditures

Useful Life of Purchas


Annual Depreciation f

Purchases of Short-Te
Purchases of Long-Ter
Interest Income Earne

Acquisition of Other C

Balance Sheet:
Assets:

General & Administrative:


Total Operating Expenses:
Depreciation:
Amortization of Intangible Assets:
Stock-Based Compensation:
Operating Income (EBIT):
Operating Margin:

50
275

50
290

10
10
20

305
46.9%

Other Income / (Expenses):


Interest Income / (Expense):
Gains / (Losses):

20
-

300
42.9%
20
(20)
(15)

Pre-Tax Income (EBT):

325

285

Income Taxes:
Current Portion:
Deferred Portion:

130
130
-

114
64
50

Net Income (Profit After Taxes):


Net Income Margin:

195 $
30.0%

Liabilities & Equity:

171
24.4%

Key Takeaways from This Lesson:

Our company (BIWS) might want to acquire another company if it has valuable assets, custome
more quickly could be anything from institutional relationships to useful Excel plug-ins or soft

When you acquire another company, you add all its Assets and Liabilities to your own Balance S
reflect the cash, debt, or stock you use to fund the deal.

Problem: Balance Sheet goes out of balance if you pay, for example, $250 for the company an
What to do? Two things:

1. Create Other Intangible Assets for items like patents, trademarks, contracts, brand value,
be estimated and quantified in some way. "Anything you can't touch and which is also not a fin

2. Plug the rest of the gap with Goodwill (Purchase Price - Seller's Equity - Other Intangibles Cr
You amortize Other Intangible Assets over their useful life, while Goodwill
Impact on Financial Statements:

Income Statement: You show the Amortization of Intangibles as an expense that reduces Pre-

Cash Flow Statement: Add back Amortization of Intangibles since it's a non-cash expense (al
Reflect the cash payment for the acquisition under Cash Flow from Investing

And reflect any debt raised or equity issued to fund the deal in Cash Flow from Financing (nothi
Balance Sheet: Add other company's Assets and Liabilities, and leave out Equity.
Adjust Cash, Debt, and Equity for the method(s) used to finance the transaction
And add in Goodwill and Other Intangible Assets on the Assets side.
Net Income vs. Cash Flow Generated: Very complex here - no simple rule because it could
the acquired company and its financial statements

In general, cash flow declines if cash is used to fund the deal. But if debt/equity are used, it ma

Net Income will reflect higher expenses (Amortization) afterward but if the other company ha
could really be anything.

to investors, or to repurchase shares, we get a better idea

n the process)

n spend their excess cash each year in addition to dividends,


eople), buying investments, and repaying debt.

r base, or something else valuable that will help you grow, then

an its future value (NPV of cash flows) to you, it makes sense to


asons than this (ego, politics, defense from the competition, etc.).

Acquisitions:

ms like Goodwill and Other Intangibles work and what they mean ets complicated, and we don't want to overload with details at this stage).

xpenses yet - it's really just 1 Founder and some interesting intellectual property (IP)
ncial modeling, software for learning the concepts, an Excel plugin that's helpful, etc.

h Flow Statement are irrelevant - nothing there yet):


How is This Possible?
Easy: the Founder started it with $130K of his own cash, which
initially went into Cash on the Assets side and Equity on the
other side
Then spent $30K of it on buying some equipment, such as
computers or other electronic devices, and also owes suppliers
for other purchases he's made but hasn't yet paid for (AP).
So what happens when we buy his company?
First off: He's not going to sell for just $100K or $130K or
something like that. After all, he already has that much or
more in Assets!
He wants some type of premium to sell his company and join
up with our team.
For established companies, you look at metrics like revenue,

operating income, net income, etc. and base the price on


those but with a start-up business like this, it's more arbitrary.
We offer him $250K for his business - not bad for him, he gets
about 2x his invested capital back after a short period of time.
Business?

bout (yet), so we just combine his Balance Sheet with ours.

wn but there's one small problem with that.

o our Balance Sheet. Remember, that's the "capital available"

its "new value", and we WIPE OUT that Equity since the

his hypothetical combination in Year 2:


Transaction Adjustments:

(250) <--- The cash we offer.

Combined:

100
50
$

(250)

100
50
340
$

871

90

290

(100) <--- Gets wiped out!


$

(100)

381

491
$

871
OK!

e Sheet not balancing when we acquire another company and pay

but would the owner really sell the company then?

eds the Equity of the acquired company (yes, same issue happens

s. Here's how it works

sets" that might be worth something

stomer/vendor relationships, brand value.

d also NOT a financial instrument (cash, investments, etc.).

and decide it's worth $50K to us, based on how much


antial yet, so that's about it for now.

mes just Intangible Assets) and "plug" part of this gap:


Here's what our allocation of the purchase price looks
like so far, with these Other Intangible Assets included:

Always write this off when you buy an entire company.


Represents our best estimate of Other Co's IP value.
Not bad! Getting closer.

premium paid above company's Equity when acquiring it.


g these "Other Intangible Assets."
Here's the "Finished" purchase price allocation:

Boom, we're done! Everything will balance now.

e Assets?

under IFRS), but they represent different things

h as contracts, patents, trademarks, relationships, etc. - anything you can

eciated. Same idea: allocate the cost over the useful life, and reflect it
n value" over time.

n the seller's Balance Sheet "future synergies!" and the simple

ys on the Balance Sheet unless it's impaired (next lesson).


you'll see an example later in the course

Capital Expenditures (Beginning of Year 2):

50

Useful Life of Purchased PP&E (# Years):


Annual Depreciation from Year 2 CapEx:

5
10

Purchases of Short-Term Investments (Year 2):


Purchases of Long-Term Investments (Year 2):
Interest Income Earned on Investments (Year 2):

$
$
$

100
100
10

Acquisition of Other Co Assumptions (Beginning of Year 2):


Purchase Price (Paid in Cash):

250

Acquired Company Cash Balance:


Acquired Company PP&E Balance:

$
$

100
30

Acquired Company Accounts Payable Balance:


Acquired Company Equity Balance:

$
$

30
100

Value of Other Intangible Assets Created:


Amortization Period of Intangible Assets:
Goodwill Created:

50
5
100

Balance Sheet:
Assets:
Current Assets:
Cash:
Short-Term Investments:
Accounts Receivable:
Inventory:
Prepaid Expenses:
Total Current Assets:

Year 1

300
300

Year 2

421
50
30
30
531

Debt Raised (Beginning


Interest Rate:
Annual Principal Repaym

Sell Short-Term Investme


Gain / (Loss) on Sale:

Issue Equity to Outside I

Dividends Issued (Year 2


Share Repurchases (Year

Cash Flow Statement:

Cash Flow from Operating A


Net Income:
Depreciation:
Amortization of Intangible A
Stock-Based Compensation
Deferred Income Taxes:
(Gains) / Losses:
Change in Operating Assets

Long-Term Assets:
Property, Plant & Equipment:
Goodwill:
Other Intangible Assets:
Long-Term Investments:
Total Long-Term Assets:
Total Assets:
Liabilities & Equity:
Current Liabilities:
Accounts Payable:
Deferred Revenue:
Total Current Liabilities:

300 $

Equity:
$

841

45
15
60

Cash Flow from Investing A


Capital Expenditures (CapE
Acquisitions:
Purchases of Short-Term Inv
Purchases of Long-Term Inve
Proceeds from ST Investmen
Cash Flow from Inves

240
50
290

300

491

Cash Flow from Financing A


Debt Raised:
Debt Principal Repayment:
Equity Issuance:
Dividends Issued:
Share Repurchases:
Cash Flow from Finan

300 $

841

Net Change in Cash:

Long-Term Liabilities:
Debt:
Deferred Tax Liability:
Total Long-Term Liabilities:

Total Liabilities & Equity:

70
100
40
100
310

Change in Accounts Receiva


Change in Prepaid Expense
Change in Inventory:
Change in Accounts Payable
Change in Deferred Revenu
Cash Flow from Opera

t has valuable assets, customers, or team members that help us grow


to useful Excel plug-ins or software.

iabilities to your own Balance Sheet, write off its Equity, and

mple, $250 for the company and its Equity is only worth $100

marks, contracts, brand value, customer relationships where the value can
uch and which is also not a financial instrument."

's Equity - Other Intangibles Created - Other Adjustments).

e Goodwill stays constant unless it's impaired (its value drops).

s an expense that reduces Pre-Tax Income and Net Income.

nce it's a non-cash expense (already paid for them in cash upfront!).

m Investing

ash Flow from Financing (nothing here).

d leave out Equity.

the transaction

o simple rule because it could be literally anything depending on

t if debt/equity are used, it may not fall.

but if the other company has revenue and expenses, the impact

bt Raised (Beginning of Year 2):


erest Rate:
nual Principal Repayment (Year 2):

300
10.0%
60

Short-Term Investments for (End of Year 2): $


n / (Loss) on Sale:
$

85
(15)

ue Equity to Outside Investors (Year 2):

100

idends Issued (Year 2):


re Repurchases (Year 2):

$
$

50
50

low Statement:

Year 1

Year 2

low from Operating Activities:

$
reciation:
ortization of Intangible Assets:
ck-Based Compensation:
erred Income Taxes:
ns) / Losses:
e in Operating Assets & Liabilities:

195
-

171
10
10
20
50
15

nge in Accounts Receivable:


nge in Prepaid Expenses:
nge in Inventory:
nge in Accounts Payable:
nge in Deferred Revenue:
Cash Flow from Operations:

low from Investing Activities:


ital Expenditures (CapEx):

chases of Short-Term Investments:


chases of Long-Term Investments:
ceeds from ST Investment Sales:
Cash Flow from Investing:

195 $

- $
- $

(50)
(30)
(30)
15
15
196

(50)
(250) <--- IMPORTANT NOTE: Normally, this is show
(100) from the acquired company is netted out. If you
(100) will actually equal the Year 2 Cash minus the Ye
85 treatment a bit, but in real life you should show
(415) the added adjustment on the Balance Sheet.

low from Financing Activities:

t Principal Repayment:
ity Issuance:
dends Issued:
re Repurchases:
Cash Flow from Financing:

ange in Cash:

$
$

- $
- $
195 $

300
(60)
100
(50)
(50)
240
21

E: Normally, this is shown as "Acquisitions, Net of Cash" and the cash


pany is netted out. If you do that, the Net Change in Cash at the bottom
Year 2 Cash minus the Year 1 Cash. We skip it here in order to simplify the
real life you should show ($150) rather than ($250) to the right, and then skip
on the Balance Sheet.