M&A transactions necessitate meticulous financial statement analysis of a target company to ascertain their health and future potential. You should examine key ratios such as profitability, growth rate and financial structure.
Examine cash and cash equivalents of the target company to ascertain its liquidity position and ability to meet short-term debt obligations. Inspect the quality, turnover and collection trends of accounts receivable. Examine valuation methods used for intangible assets as well as their remaining useful lives.
Balance Sheet
A balance sheet provides a snapshot of all assets, liabilities and shareholder equity at any given point in time. The accounting equation behind its creation is assets equal liabilities plus equity; assets include cash, inventories, buildings and machinery owned by a business while liabilities include any obligations to third parties such as accounts payables and payroll expenses owed.
Liabilities can be divided into current and non-current liabilities. Current liabilities refer to items due within one year, such as salaries owed to employees and invoices from suppliers and vendors. Non-current liabilities encompass long-term debt as well as other obligations such as taxes owed and bonds payable.
Balance sheets can also be used to calculate a company’s net worth, which is the amount left after subtracting all liabilities from total assets. This figure can help merger analysts assess whether an acquisition would be beneficial or detrimental to shareholders of both firms involved.
Income Statement
When assessing the financial stability of potential targets, one of the key documents to study is their income statement. This document shows a company’s profitability and growth potential and helps you assess how a merger or acquisition could alter their long-term health.
An income statement comprises three main sections: revenues, expenses and net income. Revenues refer to sales or any measurable sources such as interest or dividends while expenses include procurement costs, employee salaries and rent expenses along with any operating costs incurred during operations. Net income represents any surplus between revenues over expenses minus tax expenses and depreciation expenses.
Large companies require more complex income statements that focus on operating profits and margins, often reported as EBITDA (earnings before interest, taxes, depreciation and amortization), which strips out non-operating expenses to provide a clearer view of core profitability. A more sophisticated income statement should allow breakdown of this data by product lines, divisions or company departments.
Cash Flow Statement
A cash flow statement provides an accounting of all cash and cash equivalents that flow in and out of a business during a specified period. It comprises three sections, which represent operating activities, investing activities and financing activities respectively.
Operating activities, or the main business operations of a company, involve cash inflows and outflows related to sales transactions, employee wages and rent payments; it also covers noncash items like depreciation and amortization which help provide an estimate of profitability.
Investors and acquirers evaluate a target company’s ability to manage its working capital efficiently, make long-term strategic investments without incurring too much debt, and finance growth initiatives without taking on excessive debt through its investing activities section of its cash flow statement. A healthy target company features consistent positive cash flow with efficient use of current assets that enables it to meet financial obligations while having sufficient working capital reserves for unexpected expenses.
Liabilities
Liabilities represent future financial obligations of which a business is responsible. They appear on the right-hand side of a balance sheet and can be divided into current liabilities and long-term liabilities.
Reviewing financial statements of target companies during M&A due diligence provides a snapshot of their operations and ability to meet future obligations. A thorough examination reveals vital details regarding their financial health, helping ensure a fair valuation for any acquisition deal.
Current liabilities consist of accounts payable (money owed to suppliers) and accrued expenses such as wages and interest. A company’s long-term liabilities consist of mortgage payments or any debt with payment terms longer than one year. A comprehensive accounting review involves identifying and quantifying all significant current and long-term liabilities so as to ensure an accurate M&A price is set; additionally, acquirers should review target company methodology for its allowance for doubtful accounts so as to accurately reflect potential risk from uncollectible receivables.
