In the world of Mergers and Acquisitions (M&A), financial statements serve as the unexciting, yet necessary foundation for decision-making. Although they might seem a bit dull to anyone who isn’t fascinated by numbers, these documents actually provide a comprehensive story of the underlying company.
Stakeholders can use financial statements to learn how a company has performed over a given period, assess risks, identify opportunities, and align acquisition strategies with broader business goals.
With that said, let’s take a closer look at financial statements in the world of mergers & acquisitions. If you need help with M&A documents or a M&A transaction, please be sure to contact our team.
The Foundation – Overview of Financial Statements
As mentioned, financial statements tell the complete story of how a company has performed over a given period of time. If you’re not entirely sure what financial statements are, here’s what you need to know:
- What are financial statements? Financial statements are written records that convey the business activities and the financial performance of a company. They go beyond numbers on a page, serving as a narrative of a company’s fiscal health.
- What is their purpose? Financial statements exist to provide a snapshot of a company’s performance during a given period, as well as create a historical record. They offer essential insights into revenue, expenses, assets, and liabilities.
- M&A Due Diligence: As mentioned, financial statements are much more than just passive documents. They’re tools that M&A analysts wield to unearth the financial truth about a potential merger or acquisition.
Types of Financial Statements
- Income Statement: This document keeps a record of revenue, cost of goods sold (COGS), gross profit, operating expenses, and net income.
- Balance Sheet: This document provides a snapshot of a company’s assets, liabilities, and equity at a specific moment. This includes current and non-current assets, liabilities, and equity.
- Cash Flow Statement: This statement details how cash moves in and out of a business, and includes operating activities, investing activities, and financing activities.
A comprehensive understanding of financial statements is crucial for accurate M&A analysis because these documents are the key to unlocking value in a company. First, they act as the proven historical record of a business’s success – documenting sales, revenue, and profit over a given period. But, they also outline a company’s assets like buildings, machinery, intellectual property, etc.
Income Statement (Profit & Loss Statement)
When reviewing a prospective merger or acquisition’s financial documents, the income statement is arguably the most important. This is because the income statement reveals the most about a company’s profitability, viability, and overall activity.
Let’s dissect its purpose, components, and its pivotal role in M&A analysis.
Income Statement: Purpose and Components
Purpose: The income statement is a financial storyteller, narrating a company’s performance over a specified period. It details the company’s revenues, expenses, and profits, painting a vivid picture of the company’s financial journey.
Key Components
- Revenue: Sales that are recognized through the company’s primary activities.
- Cost of Goods Sold (COGS): The price paid for producing the goods or services sold.
- Gross Profit: Revenue minus COGS, which reveals the core profitability.
- Operating Expenses: The costs of running the business, including marketing, salaries, and utilities.
- Net Income: The final line in the statement, which represents the company’s profit after all expenses.
Importance in M&A Analysis
Assessing Profitability and Growth: The income statement is the go-to document for potential acquirers when assessing a company’s profitability. It lays bare whether a company is in the black or red financially and also provides insights into growth prospects – a crucial factor for those eyeing sustainable future returns.
Crucial Ratios and Metrics
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): A key metric that strips away non-operational expenses, offering a clearer picture of a company’s core profitability.
- EBITDA Margin: Calculated by dividing EBITDA by total revenue, this ratio gives a percentage that showcases the profitability of a company’s operations.
For a company, the income statement is a bit like a financial report card, highlighting how the business has performed over time. But, in M&A analysis, the income statement is more like a strategic tool. It can provide clues to understanding a company’s current standing as well as its future potential.
Balance Sheet
The balance sheet serves as a snapshot of a company’s assets, liabilities, and shareholder equity at a specific point in time. It gives prospective investors a glimpse into multiple areas of the business, and the health of the company at the time.
Overview and Structure
The balance sheet is a financial snapshot of a company’s assets, liabilities, and equity, providing a comprehensive view of its financial health. This document’s structure can be comprised of many components, differing from company to company depending on their situation and bookkeeping structure.
Below, we’ll explore a few key aspects of almost all balance sheets, including how they are utilized in the analysis of M&A documents.
Structure
- Current Assets: Cash and assets that can be converted into cash within a year.
- Non-Current Assets: Long-term assets that are valuable but cannot be sold quickly such as property, equipment, and real estate.
- Current Liabilities: Short-term debts and obligations.
- Non-Current Liabilities: Long-term debts and obligations.
- Equity: The residual interest of the company’s owners after deducting liabilities from assets.
These sections of a balance sheet will also consist of many different subsections as well, all serving to contribute to the overall financial narrative.
Key Ratios from the Balance Sheet
- Net Debt: Calculated by subtracting a company’s cash and cash equivalents from its total financial debt. It’s a critical metric in assessing a company’s ability to meet its debt obligations.
- Working Capital: The difference between a company’s current assets and current liabilities. It provides insights into short-term liquidity.
- Debt-to-Equity Ratio: A measure of a company’s financial leverage, calculated by dividing its total debt by equity. It indicates the proportion of financing that comes from debt.
- Quick Ratio (Acid-Test Ratio): Calculated by dividing a company’s liquid assets by its current liabilities. It assesses a company’s ability to cover short-term obligations with its most liquid assets.
If you’re navigating a merger or acquisition then you’ll want to pay close attention the balance sheet’s metrics. They can reveal a lot about the financial stability and potential risks of a company.
Cash Flow Statement
In the financial realm of Mergers and Acquisitions (M&A), the cash flow statement is another critical document to pay attention to. Let’s unravel its purpose, and categories, and understand why it’s a key player in M&A due diligence.
Purpose and Categories
The cash flow statement provides a detailed account of how a company generates and utilizes cash, offering insights beyond profit and loss. In this sense, it’s like a financial detective, unveiling the intricate movements of cash in and out of a business.
Categories
- Operating Activities: This category showcases the cash generated or used in the day-to-day operations of a business, including receipts from customers and payments to suppliers.
- Investing Activities: This category outlines cash flows from the purchase and sale of assets, like property, equipment, or investments.
- Financing Activities: This category delves into cash flows related to the company’s capital structure, including debt, equity, and dividend payments.
Role in M&A Due Diligence
Assessing Cash Generation and Liquidity
The cash flow statement is the litmus test for a company’s cash-generating prowess. It goes beyond profitability, providing a clearer picture of liquidity. Acquirers scrutinize this statement to evaluate how efficiently a company can meet its short-term obligations.
How Cash Flow Metrics Are Used in M&A Analysis
- Predicting Future Cash Flows: Understanding a company’s historical cash flow patterns aids in forecasting future cash flows post-merger, a crucial aspect of determining the financial viability of a deal.
- Identifying Operational Efficiency: Metrics like free cash flow (FCF) highlight how efficiently a company manages its operations. This insight is invaluable when assessing the potential synergies and cost-saving opportunities in a merger.
- Evaluating Liquidity Position: Cash flow metrics, such as the cash conversion cycle, provide a lens into a company’s liquidity position. This is pivotal in ensuring that the merged entity can weather financial challenges.
In the M&A landscape, where cash is king, the cash flow statement is key in determining whether or not a company is on solid financial footing and if it’s capable of meeting its short-term debts.
Understanding Financial Statements in M&A
On their surface, financial statements are essentially just a running financial record of a company’s financial performance. But, within these statements lies a story about how a company has performed, why it has succeeded/failed, and what its future prospects look like.
We hope that you’ve found this article valuable when it comes to learning about understanding financial statements in M&A. If you’re interested in reading more, please subscribe below to get alerted of new articles as we write them.
Need help with a merger or acquisition? Please reach out to the Acquinox team to learn more about our services! And if you need a purchase agreement template for your M&A transactions, we’ve got you covered!
