How a Fractional CFO Analyzes a P&L

How I Analyze a P&L

Analyzing a P&L is a skill that takes reps.

But it's key to understand what makes businesses run, fail, scale, and what can make one company worth so much more than another.

The more you practice, even just by simply looking at the 10-K (annual report of public companies) of multiple different businesses, you will slowly start to pick up different things like potential traps or nuisances that don’t make sense, or what a good business model looks like versus a bad business.

Here is what my typical process looks like and the questions I ask

Start at the top - Revenue

• Is the revenue predictable/recurring?
• Does it have any obvious trends?
• What is the QofQ, MoM, and YoY growth
• What drives the revenue?
  • People/payroll
  • R&D
  • Advertising
• Are there any one-time or non-recurring revenues
• Are there any revenue sources that we should discount or remove?
• Can we see revenue by business line, customer, etc?
• What’s the AOV (average order value) or ACV (average contract value)
• Any customers a significant % of revenue
  • What’s the profit on these customers‍
  • ‍What explains significant increases or decreases?
• Is the current revenue trend sustainable?

Next up, gross profit/gross margin %

Gross Margins

• Based on the business model (SaaS, DTC, etc), what do I expect the gross margins to be and are they in that range?
• Are they trending up or down?
  • Why? What is causing the trends?
• Are all of the expenses that should be in COGS/Variable Costs in COGS or are they inflating gross margin?
• If there are large variances month to month, I assume the COGS are not matched against revenues

Operating Expenses

• Are all the line items I’d expect based on the business in here?
• Are expenses growing with the business or declining
  • If declining, is that sustainable?
  • Are there any key hires needed?
• What % of the expenses are fixed expenses vs variable expenses?
  • Higher % of fixed will cause more revenue to turn into profit
• Are any expenses deflated that should be ramped back up or normalized?
• Are they continuing to spend on sales & marketing?
• What’s the revenue per employee?
• Are there any potential expense synergies?
  • For example, switching from a 3rd party fulfillment center to renting a warehouse that would reduce costs

EBIT (Operating Income) Revenues - Operating Expenses

EBIT is a proxy for core operating profit

This tells me the profitability or lack thereof of the core business operations

See below questions on profitability for questions asked on EBIT

EBITDA EBIT ^ + Depreciation + Amortization

EBITDA is a proxy for core business cash flows

Depreciation and amortization are expenses, but they have no cash impact

What this means is they are simply an accounting entry, you don’t actually pay a vendor named depreciation like you would pay Verizon for utilities

So - you add these non-cash expenses back to EBIT (core PROFIT) to get to CORE CASH FLOW

See below questions on profitability for questions asked on EBITDA

Other Income and Expenses

• Any interest expense?
  • If yes, what are the loan terms
• Any income coming in from non-core activities?

Net Income

• What is the profit margin %
• Are there any months that are abnormally low or high
• Is profit trending up or down?
• If I remove one-time revenues or non-core revenues, are we still profitable?
• If I remove non-recurring expenses or normalize expense items, how does that change the profitability

This is the list of questions I am asking ask I run down a company's P&L to analyze the business model, the performance now, and the future performance

The Story You Tell and Who You Sell To - M&A and Capital Raises

The capital markets and M&A markets have had a tide change in the last few years. We went from a near zero interest rates where capital was cheap and investors would take on more risk to 4%+ interest rates.

This increases the cost of capital -> which brings valuations down and makes businesses less profitable

All of this leads to raising capital more difficult as:

1. Investors are more selective with investments
2. Investors care more about cash flow than growth
3. Valuations coming down making founders hesitant to raise capital from investors
4. Higher interest rates on debt making taking on debt less attractive

A common misconception is if all of these ^ are impacting the public markets, where we are seeing stock prices and valuations come down, this must be having the same impact with private companies

Not so fast…

The Story You Tell

There have been plenty of times that I have seen subpar businesses or businesses generating $0 of profit or that are losing $ sell for a good chunk of change.

Why is that?

The story they are able to tell of the business and where it’s going.

A startup that I am an investor in recently pitched a large European public company on being a minority investor.

The startup is NOT generating positive cash flow currently.

What if I told you they are still commanding a MASSIVE valuation with under $10m in revenue?

How is that even possible?

We use their financial model to tell the story of where the business is now and where it’s going, and what the numbers look like when we get there

Let’s say you have 4 business locations that make money and 2 of them are new so they aren’t profitable yet

Let’s also say once you get to 5 mature locations you’ll be profitable

We need to build a financial model that depicts this and backs up this story

Why is this so important?

Investors and acquirers are going to own the business for the next x amount of years or maybe forever.

If the business is still young and has not hit critical mass, but will be wildly successful once it does, if they get in now they will be able to take advantage of reaching that critical mass point.

Who You Sell (To)

The other big factor outside of the story you tell is who you are selling the business to.

Let’s say you sell security software who sells to large corporations.

Think about the difference between these 2 buyers:

1. Buyer #1: A large private equity firm who’s never invested in security software wants to buy your business
2. Buyer #2: A large competitor who instead of selling to corporations sells to governments

Who will probably get more value out of buying the business?

Most likely, buyer #2.

Why?

Buyer #2 can probably take your software solution and up-sell or cross sell to their customers.

Buyer #2 can also probably get rid of some of the expenses because they have their own team developing software and the corporate overhead needed to run the business.

Maybe buyer #2 can get rid of the entire corporate team (CEO, CFO, COO, etc) -> that could be $1m or more in expenses cut from day 1.

Buyer #2 has more synergies (1+1 = 3)

The combination of our business and buyer #2 are worth more than the sum of the parts.

So despite everyone panicking about M&A activity, valuations, etc, because we no longer have 0% interest rates.

Even businesses that aren’t profitable can raise $ if they can tell their story right or can sell their company to the right acquirer.

Wrapping up

The ability to analyze an Income Statement is one of the most important skills somebody in business can have. As a business owner it can be invaluable in raising capital or selling your business. As a fractional CFO or head of finance, it can be the difference in good business transactions and bad ones.