- October 5, 2014
- Posted by: Treadstone Management Partners
- Category: Mergers & Acquisitions
Evaluating a prospective transaction is a critical step of any M&A deal. A successful M&A can help a company compete within its industry, but it can also be very costly. There are multiple factors companies have to look at closely in order to figure out if an M&A deal is really worth it.
Comparative ratio analysis is a tool used to evaluate financial performance. Acquiring companies may use comparative metrics as a basis for their offers and to determine whether a deal is right for them. For example, an acquiring company can use the replacement cost ratio to set up its’ offer. A replacement cost ratio determines the value of a company as the sum of all its equipment and staff.1 Another comparative metric is the discounted cash flow analysis (DCF) which determines a company’s current value according to its estimated cash flows.1 While DCF can be tricky to get right due to the unpredictability of future cash flows, it is a great tool acquiring companies can use to figure out if a prospective deal is the right one to make.
Financial Statement Analysis
Another great way an acquiring company can evaluate and analyze a prospective target is by looking at the target company’s financial statements. It’s best to start with the combined profitability of both companies; this is done by preparing a consolidated income statement.2 Is the merged company really more profitable than each company on its own? Will the merger improve the growth of both companies involved?
The next statement to look at is the balance sheet. Will the merged company hold too much debt? What are the major assets of each company and will the merger improve the utilization of these assets? 2 Finally, look at the cash flow statement. Will the merged company have more cash than each of the companies on their own? Will the merger help improve the cash flow over time?2 Of course, you can go into a lot more depth when analyzing financial statements in the evaluation of an M&A deal, but asking questions like these is a good place to start.
Strategic Impact on Your Company
In order to simplify this broad topic, its best to split it up into five subtopics: Market impact, technology impact, human resource impact, distribution impact, and supplier market impact. Market impact is the effect the M&A will have on market behavior.3 Will this merger allow the acquiring company to shift the competitive dynamic of the industry? Technology impact is the effect the merger will have on your company’s technological capabilities.3 Will this merger provide you with technology which will allow you to meet a specific customer need better than your competition? Human Resource impact is the effect of the merger on your company’s human capital.3 Will this merger provide your company with employees who have a special, in-demand skill? The distribution impact is the effect of the merger on your company’s supply chain.3 Will this merger give your company an enhanced ability to penetrate a new distribution channel? Finally, supplier market impact is the effect of the merger on your relationships with suppliers.3 Will this merger provide your company with greater bargaining power with your suppliers?
Scale vs Scope Deals
The majority of business acquisitions fall into one of two categories: scale and scope. Some companies attempt to realize both of these goals in a particular transaction, but in most case this proves too tricky to pull off. Instead, most companies look at their long-term strategic objectives in order to figure out which one of these broad categories they should pursue.4
Buyers who go for scale acquisitions are seeking an greater presence in a particular market or sector coupled with greater economies of scale.4 In a scale acquisition, the buyer typically targets a competitor in a related sector or a new geographic market with similar costs.4 Some examples of the objectives companies hope to achieve by pursuing a scale deal include:
- Reducing expenses – When two competitors join forces, they may be able to consolidate their operations, reducing their overall administrative costs and overhead expenses. The new larger entity will also enjoy greater purchasing power with suppliers and any other firm it does business with.4
- Building a capital base – An acquisition can thrust a company to the next stage in its growth cycle by giving it the capital it needs to invest in new technology and equipment that vastly improve its production volumes and product quality. Larger firms are also perceived to be less risky for investors which means lower cost financing.4
- Expanding research and development – A scale merger can enable a company to acquire a vast array of human capital which will lead to a more innovative, cost-effective R&D.4
Unlike scale acquisitions, scope deals are less about streamlining processes and cutting costs; instead, they tend to focus on diversifying a company’s operations.4 Companies that pursue scope deals are already well established in their industry, but want to move in a new direction. Companies that pursue a scope deal may have any of the following objectives in mind:
- Expand company’s breadth and geographic range – Instead of making the risky choice of expanding into a new area on their own, some companies instead use a scope acquisition as a springboard into new unfamiliar territory.4
- Open up new markets and sell to new customers – Reaching new markets and customers can be difficult, especially if a particular market has high costs of entry. A scope acquisition can mitigate some of the costs and risks which comes with new market entry by giving the acquiring firm the necessary market intelligence it needs to succeed in an unfamiliar territory.
1McClure, Ben. “Mergers and Acquisitions: Valuation Matters.” investopedia.com. Investopia, 15 May 2013. Web. 29 May 2014.
2Bell, Elizabeth, and Demand Media. “How to Evaluate a Merger Using Financial Statements.” chron.com. Chron, n.d. Web. 29 May 2014.
3Bradford, Robert. “Strategic Evaluation of Acquisition Targets.” cssp.com. CSSP, n.d. Web. 29 May 2014.
4“Scale or scope? The critical choice for business buyers.” www.extendedarticle.com. N.p., 2013. Web. 4 June 2014.