How VCs Analyze Financials: Part I, The Income Statement

posted in: Other | 0

If you have historical financial statements, your would-be venture capital investor will take high interest in them.  VCs typically look at financial statements differently than other investors, and certainly differently than a lender would.

This three part series will look at the three primary elements:  income statement, balance sheet and statement of cashflows.  Part one, the income statement follows.

(If your company is very early or seed stage, read on regardless, for insights on how to construct your financial statements once expansion materializes.)

The first stop on the income statement are usually the gross, operating and net margins to see if they are in line with industry averages. Next, they’ll tend to look at the trends in contributions to revenues if the company has more than one product or line. Ideally, revenue figures will show a trend toward the higher margin products/services over time.

In addition, most investors will be looking at whether or not the revenues are recurring in nature — that is, are they coming from new or existing customers? It’s much less expensive to generate revenues from existing customers than it is to go out and find new ones. If the revenue structure is a recurring one, it’s easier to make the case for growing margins over time.”

Next, general and administrative expenses. If these are high by industry standards, it’s not necessarily a negative, if you can make the case you’re simply managing income for tax purposes. After all, that’s what small business owners are supposed to do. When general and administrative expenses pose a problem to investors is when the organization is plain top heavy because it’s a sign of management shortcomings.

Next, if there’s not R&D on the balance sheet in the form of capitalized expenditures, then most investors will be looking for some R&D expenses to show up on the income statement. Of course, this mainly applies to technology companies, where innovation offers an edge. R&D can be a very important factor for leading edge technology companies, because innovation is the force that will drive future revenues.  At Intel for instance, R&D was about 21% of its $55 billion in 2015 revenues.

In addition to the overall volume of expenses, says most equity investors will also look at the trend relative to revenues. They’re looking for operating leverage. Ideally, the company is engaged in a business where operating expenses, as a percentage of sales, decrease as sales increase.

Operating leverage is a significant benefit, since under those conditions, the company becomes more profitable, hence more valuable, the larger it gets. For instance, at Apple, the company was able to increase revenues by about $66 billion between 2013 and 2015, with an increase of just $7 billion in operating expenses.  That’s leverage.

Stepping back and looking at the income statement, an investor might wonder if a more conservative approach to revenue recognition would turn what appears to be a profit into a loss. Deferred expenses, questionable gains or losses, low returns and allowances charges relative to industry averages or lax revenue recognition policies might all conspire to make the entire presentation look questionable, or worse, turn a profit into a loss.

Part II, The Statement Of Cashflows will be published next week.