Income statement and profitability. The next theory that financial risk looks at are the profitability or earnings of the company which measure the performance of the business. Why is this important for credit analysis? Financial performance has historically been measured by earnings, and we still communicate earnings to the investment in stakeholder community. Valuations, including LBOs which are heavily dependent on leverage are still quoted in terms of multiples of earnings. EBIT & EBITDA which are derived from the income statement are the most common metrics in the credit world just as they are in other areas of finance. EBITDA is one of the most often quoted metrics in covenants and in ratio analysis as a proxy for cash. This is not to confuse EBITDA with cash as there are major differences which we will discuss in a later section. The entire income statement is built on accrual accounting. It tells us nothing about cash which is what the credit analyst is most concerned about. The revenue on the income statement are also non-cash and represent only where revenue has been recognized. There are three principles of revenue recognition that it is recognized upon delivery of goods or performance of service not when the actual sale is made, that any costs associated with that sale must be recognized in the same period. This is called a matching principle, and that revenue and cash flow therefore rarely happen at the same time. Here are three examples of revenue recognition. In the first, we see a retailer delivering the good and recognizing the sale and receiving the cash almost immediately. In the second, we see an airline reservation receiving the cash, but not recognizing the sale until they deliver the service which is letting the passenger fly on the aircraft. And lastly, we see a manufacturer selling a good and delivering the product, therefore recognizing the sale, but then not receiving cash until much later when the invoice is paid. For a non-financial and a non-service company, a company's cost can be broken down in the following way. At the top, we have the cost of goods sold or the cost to make or buy the product. Below that, we have the remaining operating costs which support the operations, after that are the financing costs and lastly the taxes. Whereas M and A evaluation are ultimately focused on EPS, credit is an EBITDA-operating profit-focused business. There's not much below EBITDA from an earnings perspective that the credit analysis is interested in.