Breaking Into Wall Street - The 3 Financial Statements($ in Thousands)

share repurchases, more CapEx, more operating expenses (hiring people), buying investments, and repaying debt.

If you think another company has an asset, or a team, or a customer base, or something else valuable that will help you grow, thenit might make sense to acquire that other company.

do the deal… although a lot of deals are done for far less rational reasons than this (ego, politics, defense from the competition, etc.).

Our Scenario - INTRODUCTION to Accounting for Mergers & Acquisitions:

we go into it in a lot more detail in the Merger Module modules (it gets complicated, and we don't want to overload with details at this stage).

he has developed. Might be a new training method for learning financial modeling, software for learning the concepts, an Excel plugin that's helpful, etc.

Here's what its Balance Sheet looks like (Income Statement and Cash Flow Statement are irrelevant - nothing there yet):

Balance Sheet: Year 1 How is This Possible?

Assets: Easy: the Founder started it with $130K of his own cash, which Current Assets: initially went into Cash on the Assets side and Equity on the

Cash: $ 100 other side…Total Current Assets: 100

Then spent $30K of it on buying some equipment, such as Long-Term Assets: computers or other electronic devices, and also owes suppliers

Property, Plant & Equipment: 30 for other purchases he's made but hasn't yet paid for (AP).Total Long-Term Assets: 30

So… what happens when we buy his company?Total Assets: $ 130

First off: He's not going to sell for just $100K or $130K or Liabilities & Equity: something like that. After all, he already has that much or

Current Liabilities: more in Assets!Accounts Payable: $ 30

Total Current Liabilities: 30 up with our team.

Long-Term Liabilities:Debt: - For established companies, you look at metrics like revenue,

Concept: Rather than using all of our excess cash to pay dividends to investors, or to repurchase shares, we get a better idea…

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 year… in addition to dividends,

Put simply: if you think the price you pay for the company is less than its future value (NPV of cash flows) to you, it makes sense to

This is JUST an introduction to the basics so you understand how items like Goodwill and Other Intangibles work and what they mean -

We find a promising young start-up company with no revenue or expenses yet - it's really just 1 Founder and some interesting intellectual property (IP)

He wants some type of

Total Long-Term Liabilities: - operating income, net income, etc. and base the price on those… but with a start-up business like this, it's more arbitrary.

Equity: 100

Total Liabilities & Equity: $ 130 about 2x his invested capital back after a short period of time.

So What Happens Next After We Offer Him the $250K for His Business?

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

Balance Sheets @ Year 2 End: BIWS Other Co.

Assets:Total Current Assets: $ 531 $ 100

Goodwill: - - Other Intangible Assets: - - Total Long-Term Assets: 310 30

Total Assets: $ 841 $ 130

Liabilities & Equity:Total Current Liabilities: $ 60 $ 30

Total Long-Term Liabilities: 290 -

Equity: 491 100

Total Liabilities & Equity: $ 841 $ 130

BALANCE CHECK: OK! OK!

something DIFFERENT from the value of its Equity on the Balance Sheet.

We offer him

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 problem with that.

According to accounting rules, we do NOT just add his Equity to our Balance Sheet. Remember, that's the "capital available"…to THAT old company that no longer exists!

BUT… that creates a big problem in the model. Take a look at this hypothetical combination in Year 2:

So we will almost always run into this issue of the combined Balance Sheet not balancing when we acquire another company and pay

IF we paid only $100K for the company, we wouldn't have this issue… but would the owner really sell the company then?

We need something to "plug the gap" when the Purchase Price exceeds the Equity of the acquired company (yes, same issue happenseven when we use debt to buy it, or issue stock to buy it, or anything else).

So let's say we look at Other Co's new, snazzy intellectual property, and decide it's worth $50K to us, based on how muchin future cash flows it could add to our business. Nothing else substantial yet, so that's about it for now.

Purchase Price Allocation: Year 2 Here's what our allocation of the purchase price looks like so far, with these Other Intangible Assets included:

Purchase Price: $ 250

Write-Off of Seller's Equity: 100 <---------------------Always write this off when you buy an entire company.Other Intangible Assets: 50 <---------------------Represents our best estimate of Other Co's IP value.

Total Allocation: $ 150 <---------------------Not bad! Getting closer.

"The Gap": $ 100

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

… and the premium above other adjustments we've made, including these "Other Intangible Assets."

Purchase Price Allocation: Year 2 Here's the "Finished" purchase price allocation:

Purchase Price: $ 250

Write-Off of Seller's Equity: 100 Other Intangible Assets: 50 Goodwill: 100

Total Allocation: $ 250

"The Gap": $ - <---------------------Boom, we're done! Everything will balance now.

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

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 something…

Examples: Patents, trademarks, intellectual property, contracts, customer/vendor relationships, brand value.

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

We create a new line item called Other Intangible Assets (sometimes just Intangible Assets

We create another new asset called Goodwill, which represents the premium paid above company's Equity

Both are created only in the course of acquisitions (not exactly true under IFRS), but they represent different things…

Other Intangible Assets: Correspond to identifiable assets, such as contracts, patents, trademarks, relationships, etc. - anything you can

name and explain why it's worth something.

on the Income Statement… reflects how these assets also "decline in value" over time.

premium you pay over the company's Balance Sheet value.

Example in Our 3-Statement Model:

Tax Rate: 40.0% Capital Expenditures (Beginning of Year 2):

Inventory Purchases (Year 2): $ 30 Useful Life of Purchased PP&E (# Years):Deferred Revenue Additions (Year 2): $ 15 Annual Depreciation from Year 2 CapEx:Accounts Payable Additions (Year 2): $ 15 Prepaid Expense Additions (Year 2): $ 30 Purchases of Short-Term Investments (Year 2):Accounts Receivable Additions (Year 2): $ 50 Purchases of Long-Term Investments (Year 2):

Interest Income Earned on Investments (Year 2):Deferred Income Taxes (Year 2): $ 50 Stock-Based Compensation (Year 2): $ 20 Acquisition of Other Co Assumptions (Beginning of Year 2):

Income Statement: Year 1 Year 2 Balance Sheet:

Revenue: $ 650 $ 700 Assets:Cost of Goods Sold (COGS): 70 70

Gross Profit: 580 630 Gross Margin %: 89.2% 90.0%

Operating Expenses:Sales & Marketing: 150 165 Research & Development: 75 75

These also get amortized over time, just like how PP&E gets depreciated. Same idea: allocate the cost over the useful life, and reflect it

Goodwill: Corresponds to assets that cannot be readily identified on the seller's Balance Sheet… "future synergies!" and the simple

Under US GAAP and IFRS, Goodwill is not amortized and simply stays on the Balance Sheet unless it's impaired (next lesson).

Ninja Tip: This is not true under all accounting systems worldwide - you'll see an example later in the course…

General & Administrative: 50 50 Total Operating Expenses: 275 290

Depreciation: - 10 Amortization of Intangible Assets: - 10 Stock-Based Compensation: - 20

Operating Income (EBIT): 305 300 Operating Margin: 46.9% 42.9%

Other Income / (Expenses): 20 20 Liabilities & Equity:Interest Income / (Expense): - (20)Gains / (Losses): - (15)

Pre-Tax Income (EBT): 325 285

Income Taxes: 130 114 Current Portion: 130 64 Deferred Portion: - 50

Net Income (Profit After Taxes): $ 195 $ 171 Net Income Margin: 30.0% 24.4%

Key Takeaways from This Lesson:

more quickly… could be anything from institutional relationships to useful Excel plug-ins or software.

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

What to do? Two things:

be estimated and quantified in some way. "Anything you can't touch and which is also not a financial instrument."

Impact on Financial Statements:

Our company (BIWS) might want to acquire another company if it has valuable assets, customers, or team members that help us grow

Problem: Balance Sheet goes out of balance if you pay, for example, $250 for the company and its Equity is only worth $100…

1. Create Other Intangible Assets for items like patents, trademarks, contracts, brand value, customer relationships where the value can

2. Plug the rest of the gap with Goodwill (Purchase Price - Seller's Equity - Other Intangibles Created - Other Adjustments).

You amortize Other Intangible Assets over their useful life, while Goodwill

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

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 (nothing here).

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.

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 may not fall.

Net Income will reflect higher expenses (Amortization) afterward… but if the other company has revenue and expenses, the impactcould really be anything.

Cash Flow Statement: Add back Amortization of Intangibles since it's a non-cash expense (already paid for them in cash upfront!).

Balance Sheet: Add other company's Assets and Liabilities, and leave out Equity.

Net Income vs. Cash Flow Generated: Very complex here - no simple rule because it could be literally anything depending on

share repurchases, more CapEx, more operating expenses (hiring people), buying investments, and repaying debt.

If you think another company has an asset, or a team, or a customer base, or something else valuable that will help you grow, then

do the deal… although a lot of deals are done for far less rational reasons than this (ego, politics, defense from the competition, etc.).

Our Scenario - INTRODUCTION to Accounting for Mergers & Acquisitions:

we go into it in a lot more detail in the Merger Module modules (it gets complicated, and we don't want to overload with details at this stage).

he has developed. Might be a new training method for learning financial modeling, software for learning the concepts, an Excel plugin that's helpful, etc.

Here's what its Balance Sheet looks like (Income Statement and Cash 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 suppliersfor 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!

up with our team.

For established companies, you look at metrics like revenue,

Rather than using all of our excess cash to pay dividends to investors, or to repurchase shares, we get a better idea…

(And gain useful assets in the process)

Acquisitions are just another way that companies can spend their excess cash each year… in addition to dividends,

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

an introduction to the basics so you understand how items like Goodwill and Other Intangibles work and what they mean -

no revenue or expenses yet - it's really just 1 Founder and some interesting intellectual property (IP)

He wants some type of premium to sell his company and join

operating income, net income, etc. and base the price on those… but with a start-up business like this, it's more arbitrary.

about 2x his invested capital back after a short period of time.

So What Happens Next After We Offer Him the $250K for His Business?

When we acquire it, the cash we pay for the company represents its "new value", and we WIPE OUT that Equity since the

Transaction Adjustments: Combined:

$ (250) <--- The cash we offer. $ 381

100 100 50 50 - 340

$ (250) $ 871

$ - $ 90

- 290

(100) <--- Gets wiped out! 491

$ (100) $ 871

OK!

We offer him $250K for his business - not bad for him, he gets

There's no Income Statement or Cash Flow Statement to worry about (yet), so we just combine his Balance Sheet with ours.

So, we literally ADD his company's Assets and Liabilities to our own… but there's one small problem with that.

, we do NOT just add his Equity to our Balance Sheet. Remember, that's the "capital available"…

in the model. Take a look at this hypothetical combination in Year 2:

run into this issue of the combined Balance Sheet not balancing when we acquire another company and pay

we paid only $100K for the company, we wouldn't have this issue… but would the owner really sell the company then?

We need something to "plug the gap" when the Purchase Price exceeds the Equity of the acquired company (yes, same issue happens

So let's say we look at Other Co's new, snazzy intellectual property, and decide it's worth $50K to us, based on how muchin future cash flows it could add to our business. Nothing else substantial yet, so that's about it for now.

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.

… and the premium above other adjustments we've made, including these "Other Intangible Assets."

Here's the "Finished" purchase price allocation:

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

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

Goodwill and Other Intangible Assets. Here's how it works…

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

Patents, trademarks, intellectual property, contracts, customer/vendor relationships, brand value.

a physical asset you can touch, and also NOT a financial instrument (cash, investments, etc.).

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

, which represents the premium paid above company's Equity when acquiring it.

true under IFRS), but they represent different things…

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

on the Income Statement… reflects how these assets also "decline in value" over time.

Capital Expenditures (Beginning of Year 2): $ 50 Debt Raised (Beginning of Year 2):Interest Rate:

Useful Life of Purchased PP&E (# Years): 5 Annual Principal Repayment (Year 2):Annual Depreciation from Year 2 CapEx: $ 10

Sell Short-Term Investments for (End of Year 2):Purchases of Short-Term Investments (Year 2): $ 100 Gain / (Loss) on Sale:Purchases of Long-Term Investments (Year 2): $ 100 Interest Income Earned on Investments (Year 2): $ 10 Issue Equity to Outside Investors (Year 2):

Acquisition of Other Co Assumptions (Beginning of Year 2): Dividends Issued (Year 2):Share Repurchases (Year 2):

Purchase Price (Paid in Cash): $ 250

Acquired Company Cash Balance: $ 100 Acquired Company PP&E Balance: $ 30

Acquired Company Accounts Payable Balance: $ 30 Acquired Company Equity Balance: $ 100

Value of Other Intangible Assets Created: $ 50 Amortization Period of Intangible Assets: 5 Goodwill Created: $ 100

Balance Sheet: Year 1 Year 2 Cash Flow Statement:

Assets: Cash Flow from Operating Activities:Current Assets: Net Income:

Cash: $ 300 $ 421 Depreciation:Short-Term Investments: - - Amortization of Intangible Assets:Accounts Receivable: - 50 Stock-Based Compensation:Inventory: - 30 Deferred Income Taxes:Prepaid Expenses: - 30 (Gains) / Losses:

Total Current Assets: 300 531 Change in Operating Assets & Liabilities:

depreciated. Same idea: allocate the cost over the useful life, and reflect it

be readily identified on the seller's Balance Sheet… "future synergies!" and the simple

amortized and simply stays on the Balance Sheet unless it's impaired (next lesson).

true under all accounting systems worldwide - you'll see an example later in the course…

Change in Accounts Receivable:Long-Term Assets: Change in Prepaid Expenses:

Property, Plant & Equipment: - 70 Change in Inventory:Goodwill: - 100 Change in Accounts Payable:Other Intangible Assets: - 40 Change in Deferred Revenue:Long-Term Investments: - 100 Cash Flow from Operations:

Total Long-Term Assets: - 310 Cash Flow from Investing Activities:

Total Assets: $ 300 $ 841 Capital Expenditures (CapEx):Acquisitions:

Liabilities & Equity: Purchases of Short-Term Investments:Current Liabilities: Purchases of Long-Term Investments:

Accounts Payable: $ - $ 45 Proceeds from ST Investment Sales:Deferred Revenue: - 15 Cash Flow from Investing:

Total Current Liabilities: - 60 Cash Flow from Financing Activities:

Long-Term Liabilities: Debt Raised:Debt: - 240 Debt Principal Repayment:Deferred Tax Liability: - 50 Equity Issuance:

Total Long-Term Liabilities: - 290 Dividends Issued:Share Repurchases:

Equity: 300 491 Cash Flow from Financing:

Total Liabilities & Equity: $ 300 $ 841 Net Change in Cash:

more quickly… could be anything from institutional relationships to useful Excel plug-ins or software.

When you acquire another company, you add all its Assets and Liabilities to your own Balance Sheet, write off its Equity, and

be estimated and quantified in some way. "Anything you can't touch and which is also not a financial instrument."

company if it has valuable assets, customers, or team members that help us grow

Balance Sheet goes out of balance if you pay, for example, $250 for the company and its Equity is only worth $100…

for items like patents, trademarks, contracts, brand value, customer relationships where the value can

(Purchase Price - Seller's Equity - Other Intangibles Created - Other Adjustments).

Other Intangible Assets over their useful life, while Goodwill stays constant unless it's impaired (its value drops).

You show the Amortization of Intangibles as an expense that reduces Pre-Tax Income and Net Income.

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 (nothing here).

Adjust Cash, Debt, and Equity for the method(s) used to finance the transaction…

In general, cash flow declines if cash is used to fund the deal. But if debt/equity are used, it may not fall.

Net Income will reflect higher expenses (Amortization) afterward… but if the other company has revenue and expenses, the impact

Add back Amortization of Intangibles since it's a non-cash expense (already paid for them in cash upfront!).

Add other company's Assets and Liabilities, and leave out Equity.

Very complex here - no simple rule because it could be literally anything depending on

Debt Raised (Beginning of Year 2): $ 300 Interest Rate: 10.0%Annual Principal Repayment (Year 2): $ 60

Sell Short-Term Investments for (End of Year 2): $ 85 Gain / (Loss) on Sale: $ (15)

Issue Equity to Outside Investors (Year 2): $ 100

Dividends Issued (Year 2): $ 50 Share Repurchases (Year 2): $ 50

Cash Flow Statement: Year 1 Year 2

Cash Flow from Operating Activities: $ 195 $ 171

Depreciation: - 10 Amortization of Intangible Assets: - 10 Stock-Based Compensation: - 20 Deferred Income Taxes: - 50 (Gains) / Losses: - 15

Change in Operating Assets & Liabilities:

Change in Accounts Receivable: - (50)Change in Prepaid Expenses: - (30)Change in Inventory: - (30)Change in Accounts Payable: - 15 Change in Deferred Revenue: - 15

Cash Flow from Operations: $ 195 $ 196

Cash Flow from Investing Activities:Capital Expenditures (CapEx): $ - $ (50)

- (250)Purchases of Short-Term Investments: - (100) from the acquired company is netted out. If you do that, the Net Change in Cash at the bottomPurchases of Long-Term Investments: - (100) will actually equal the Year 2 Cash minus the Year 1 Cash. We skip it here in order to simplify the Proceeds from ST Investment Sales: - 85 treatment a bit, but in real life you should show ($150) rather than ($250) to the right, and then skip

Cash Flow from Investing: $ - $ (415) the added adjustment on the Balance Sheet.

Cash Flow from Financing Activities: $ - $ 300

Debt Principal Repayment: - (60)Equity Issuance: - 100 Dividends Issued: - (50)Share Repurchases: - (50)

Cash Flow from Financing: $ - $ 240

Net Change in Cash: $ 195 $ 21

<--- IMPORTANT NOTE: Normally, this is shown as "Acquisitions, Net of Cash" and the cash

from the acquired company is netted out. If you do that, the Net Change in Cash at the bottomwill actually equal the Year 2 Cash minus the Year 1 Cash. We skip it here in order to simplify the treatment a bit, but in real life you should show ($150) rather than ($250) to the right, and then skipthe added adjustment on the Balance Sheet.

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