Why Balance sheet analysis is critical in Mergers and Acquisitions?

A Balance sheet is a snapshot of the Target company’s financial position at a particular timeframe.

Balance sheet is a statement of a company’s Assets and Liabilities. The company invests in Assets that can generate revenues for the company.This asset is financed through liabilities generally debt or with owners equity.

During the acquisition it is critical to analyse the balance sheet of the target company during the due diligence to derive important insights of the financial condition of the target company. This shall help the acquiring firm to make adjustment to its Valuation depending on the findings

Working Capital Analysis

A very important condition while finalizing the term sheet or LoI is that acquiring company would take over the target company at cash free debt free regular working capital that would be easier for acquiring company to continue operations without injecting any funds from its end

Important indicators here would be the

• Current Assets and
• Current Liabilities

Current Assets would include Cash, Inventory, Prepaid expenses and Accounts Receivable

• Cash position — It is important that the company has sufficient cash and marketable securities to cover for any unforeseen short term liquidity risks.At the same time having huge cash reserves is not good as this indicates that the company is finding difficulties to look at investing this cash reserves to deliver shareholder returns
• Inventory position — The company generally keeps sufficient stock of its goods so that it can match the demand.In IT services, the inventory are the human capital who are kept in bench so that they can be deployed immediately when there is a project requirement.High inventory costs means that the target company is unable to forecast the market demand properly or that the goods or services rendered by the target firm are no longer in demand in the market.In such cases generally the goods are sold at discounted value to get some income and if the same is not possible then they are written off.
• Accounts Receivable — This is the money that is needed to be collected by the company from its customers for providing its services.The faster the company is able to collect money from customer lower the default risk.Higher ageing of receivables can put the company in cash crunch and might force it to borrow money from market to cover it’s current liabilities. Sometimes the company would have a lenient payment terms with its customers in order to generate more sales.This should be seen as a red flag by the buyer during due diligence as this means the company is not getting more sales due to its differentiated service offerings

Current Liabilities

This generally involves:

• Account Payables — This would entail paying money to suppliers for their services.Generally it is a good norm that the company extend its account payables period compared to account receivables. This means that the company has a good bargaining position with its suppliers.At the same time extending this time beyond a certain point could put the company in a bad light as suppliers would no longer want to work with the company.
• Short term Loans — This is generally the loans taken to fund the company operations.These loans are generally repaid within 1 year.

Other component in the current liabilities would cover Salaries paid, Taxes etc.

Fixed Assets or Capex Analysis

A company invest in fixed assets like machinery, real estate and in R&D to generate revenues.These cannot be liquidated immediately and would be used for a longer period.Hence these are depreciated or amortized annually and are expensed in Income statement to reduce tax outflow.

Debt Analysis

If the company uses long term debt to finance its assets then it is important to look at this very closely.It is also important to check if the interest payments for such loans are paid with the company’s earnings.If not then this is a red flag as the inability to pay the interest payments would reduce the credit rating of the target firm and at the same time its Equity value would also reduce as the amount available for its investors as dividend payments would be less.

Shareholders Equity

This position generally gives an idea of the corporate structure of the target company and its shareholding pattern.

Important components here would be:

• Capital stock — This would be the amount invested by the equity investors towards the company or the amount the company raise for it IPO
• Retained Earnings — This is the amount the company intends to payback its shareholders from its annual earnings as dividend payments.A company that regularly pays dividend to its shareholders would have a higher equity value.In some cases the company might intend to reinvest a part of earnings for long term growth either as of investments, R&D or acquisitions.If the company can persuade to its shareholders that this strategy is primarily to increase their value the this might also increase its equity value.

Conclusion

Hence during an acquisition, analyzing the target company balance sheet is extremely critical as it gives insights about target company on its

• Working Capital Condition
• Debt situation
• Equity value

Any outputs from this due diligence would have a substantial impact on Final Valuation along with indemnification provision that buyer would demand from the seller as form in final Sale and Purchase Agreement