How to use financial analysis to prepare for an acquisition or merger

The catalysts for contemplating a merger or acquisition are multiple. You may want to increase your financial footprint or expand your market share by taking on a competitor’s customers. Bolting on a target’s know-how to expand a product catalogue is another motive.

The investment climate is showing signs of heating up in several key economies, fuelled by lower valuations and low interest rates, with a rebound of business investment in, software and IT equipment. But other opportunities will soon become evident as the habits customers began adopting at the start of the pandemic take hold. How can you prepare your company?  

Acquisitions – the thrill of the chase - are exciting events. But before rushing to launch a takeover or merger you should do your homework to make sure that the company in your sights fulfils several basic criteria:

• Is it financially sound?
• Is it a good fit with the rest of your activities?
• Does it offer attractive and rewarding synergies?

Before making an offer, take a deep dive into your target’s financial statements to analyse its past performance, paying special attention to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), working capital and debt levels.

Now look closely at the target’s balance sheet. An excessive debt-to-equity ratio should be a red flag. How will this additional debt load impact your credit rating?

Next stop is the cash flow statement to give you an idea of the target’s capacity to service its debt. The income statement can provide a glimpse of the target’s profitability and top-line momentum. Be sure to scrutinise both historical and forward-looking financials.

Remember: numbers alone won’t provide adequate information. You want to check out a company’s reputation, its banking relationships, its relationships with customers and suppliers.

Another consideration is how the target and its ecosystem have been affected by the Covid-19 crisis. How has it adjusted its product lines, capacity or management philosophy due to shifts in its industry?  Predictably, sectors such as IT and software are doing better than others, such as hospitality and travel.

Draw up a hypothetical post-merger income statement that takes into account potential synergies, estimating the positive impact of increased market share as well as potential benefits from synergies.

Broaden your investigation to include information on the company’s industry: what is the sector’s growth potential? Your target should be well-situated in comparison with its peers and competitors.

Any acquisition can have an impact on your company’s working capital. Expanded activity generates more costs and requires more cash. If you don’t have plenty of liquidity on hand, you must be able to increase your credit line. If you are selling 100 objects a month now and want to increase that number to 150, you must be able to increase your working capital by 50%.

In the same vein, consider how you will fund this acquisition. Taking on debt will affect your debt/equity ratio. Do the sales and profitability deltas of the combined operation justify the increased leverage?

Other less tangible factors to take into account include integration risk arising from the culture and practices of the target. Will it be plug-and-play, or will integration take 3, 5 or 10 years? Be prepared for a few glitches in your plans and be flexible.

Don’t imagine that the plans you created at the beginning of the year are still viable. Draw up alternative scenarios. Create a Plan B (or C), for instance if you’ve overestimated potential synergies. It’s better to be conservative early on than to find later you’ve put your company at risk.

Finally, embarking on a merger/takeover is a huge distraction for management from running a firm’s day-to-day business. Undertaking precise analysis, verification and research required for a successful operation absorbs time and labour.

Trade credit insurance  can protect your business against the risk of financial loss from non-payment of a commercial trade debt, a particularly important consideration in the uncharted operational field that can follow an acquisition or a merger.

For more tips and advice on business financial monitoring, download our ebook: Boost your financial performance analysis.