drives them. One issue that hasn't been addressed is the role Revenue plays in covering all the expenses incurred by a business. For example, for any given level of Net Income the Revenue must be adequate to cover the Cost of Goods Sold, Operating Expenses, Depreciation and Amortization, Net Interest, and Taxes. In this section, instead of starting with Revenue, the Income Statement will be worked backward, so to speak, and start with Net Income and end up with the Required Revenue to support the Net Income.
The analysis of Required Revenue begins by referring to Table 1-7 and then letting “RR” represent the Required Revenue to drive a level of Net Income.
Table 1-7 Income Statement for Calculating Required Revenue
By inspection:
[1-56]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid
or
[1-57]NI = Rev − (COGSRatio)(Rev) − (OpExpRatio)(Rev)
− D & A ± NetInt − TaxesPaid
where:
COGS = (COGSRatio)(Rev) and OpExp = (OpExpRatio)(Rev)
If Rev is the Required Revenue (RR) to deliver Net Income NI, then
[1-58]NI = RR − (COGSRatio)(RR) − (OpExpRatio)(RR)
− D & A ± NetInt − TaxesPaid
Factoring,
[1-59]NI = (RR)(1 − COGSRatio − OpExpRatio) − D & A ± NetInt − TaxesPaid
Rearranging,
[1-60]RR(1 − COGS Ratio − OpExpRatio) = NI + D & A ± NetInt + TaxesPaid
Dividing both sides of [1-60] by (1 − COGSRatio − OpExpRatio),
[1-61]
Again by inspection of Table 1-7 it can be seen that
[1-62](1 − COGSRatio − OpExpRatio) = EBITDARatio
Substituting [1-62] in Equation [1-61], the revenue required (Required Revenue) to support a given level of Net Income is obtained:
[1-63]
or
[1-64]
Equation [1-64] tells an interesting story. It says that for a given level of financial performance the Revenue must be sufficient to cover the expected Net Income, Depreciation and Amortization, any Interest Expense, and Taxes Paid.25
Also, since
[1-8]TaxesPaid = (EBT)(TR)
then another form of Equation [1-64] is
[1-65]
Example 1-7: Calculating Required Revenue
Del Rey Corporation has a budgeted Net Income of $2,495,000 in Year 1 of its operating plan with an EBITDA of 11.5 %. If Depreciation and Amortization, Net Interest, and Taxes Paid are $1,735,000, $0, and $1,828,000 respectively, calculate the Required Revenue for each term in Equation [1-65] and the Total Required Revenue for Year 1 of the operating plan (Table 1-8).
Table 1-8 Condensed Income Statement for Del Rey Corporation
The Required Revenue to support the Net Income NI1 of $2,495,000 is
Repeating this process, the Required Revenue for D&A, NetInt, and TaxPaid can be calculated.
Substituting in Equation [1-65] gives the Required Revenue in Year 1.
RR 1 = 21,696,000 + 15,087,000 + 0 + 15,896,000
RR 1 = $52,679,000
As can be seen from the example, approximately $15 million and $16 million of Revenue are required to cover Depreciation and Amortization and Taxes respectively, whereas roughly $21,700,000 of revenue is required to deliver the Year 1 Net Income in the operating plan.26
⧉ Case Study: Advanced Solar Systems Corporation
Ms. Engel has just returned from completing an Executive Management Program at the University of Pennsylvania's Wharton School. In keeping with the school's reputation the program had an emphasis on developing quantitative skills, which wasn't a problem for Ms. Engel since she had a degree in electrical engineering. The assignment from the Professor of Finance who conducted the concluding session was for all participants to do an analysis of their company's financial statements using the skills they had just developed when they returned to their offices.
Ms. Engel's employer is Advanced Solar Systems Corporation. As the name would suggest, the Company specializes in systems that utilize solar technology to build power sources for the military and aerospace industries. One of the things that was stressed by the professors conducting the program was that while all students should have a solid grasp of the relationships they were taught that defined the financial statements, they should also remember that the statements are logical, and with a little practice they can be analyzed by running some simple calculations based on inspection rather than rigorous mathematical treatment. With this in mind and after scanning the Solar Systems Income Statement, Ms. Engel did a comparative analysis of the actual results for the Prior Year and the forecast for the Current Year. The Income Statement including the analysis is shown in Table CS 1-1.
Table CS 1-1 Advanced Solar Systems Comparative Income Statement
After looking at the Comparative Analysis, Ms Engel concluded:
• Revenue increased 12 % on a year-over-year basis driven by the demand for the company's products, what one expects of a growth company.
• The Cost of Goods Sold (COGS) had increased by 100 basis points (1 %) from 56 % to 57 %. While this is a movement in the wrong direction, it was not unexpected given the startup costs associated with the products that had been released to production at the end of the Prior Year.
• As a result of the deterioration in the COGS, the Gross Margin (GM) decreased to 43 %.
• Operating Expense decreased from 27 % to 24.5 % but in absolute terms increased slightly to $307,632,000. The reduction in percentage terms was to be expected given the Revenue Growth. The modest increase was made possible by the reduction in R&D expenses associated with the new products that were released to production at the end of Prior Year.
• Driven by the Revenue and OpExp the EBITDA increased 150 basis points (1.5 %) to 18.5 %, which is in keeping with the operating leverage obtained by managing the Operating Expenses while increasing Revenue.
• Depreciation increased from 3 % to 3.2 % of Revenue as the company continued to invest to keep up with demand and technology.
• Since the company was debt-free