The Importance of Financial Analysis in Mergers and Acquisitions (M&A) Transactions (2024)

Mergers and acquisitions (M&A) transactions require careful examination of various aspects to ensure a successful deal. We will delve into the significance of financial analysis during due diligence and explore two fundamental approaches: fundamental analysis and technical analysis. By understanding these concepts, startups and entrepreneurs can gain valuable insights into their business's financial performance and prospects.

The Role of Due Diligence:

Due diligence plays a pivotal role in M&A transactions, allowing the acquiring party to gather vital information about the target company. This process encompasses a comprehensive evaluation of legalities, finances, technical and commercial aspects. Financial analysis is one of the most critical components of due diligence.

Financial Due Diligence:

The financial due diligence involves an investigative analysis of a company's financial situation and prospects. Typically conducted by external parties, this analysis aims to achieve several objectives:

1. Comprehensive Overview: Financial due diligence provides a comprehensive overview of the target company's financial situation and growth potential. Investors can understand the company's current and projected financial health by analysing financial data, trends, and forecasts. This includes assessing the company's revenue streams, cost structure, profitability, and cash flow patterns.
2. Uncovering Hidden Issues: Financial analysis helps reveal potential issues that may not be readily apparent in the financial statements. Analysts can identify anomalies, risks, and other factors impacting the company's performance by examining financial data in detail. This includes assessing the quality of earnings, identifying potential contingent liabilities, evaluating the effectiveness of internal controls, and reviewing any potential legal or regulatory issues.
3. Validating Business Plan and Metrics: Financial due diligence involves validating the target company's business plan and the metrics used for valuation. This process focuses on evaluating the viability and reliability of the assumptions and projections made in the business plan rather than solely relying on historical performance. By scrutinising the underlying financial models, market analysis, and growth projections, investors can assess the reasonableness of the target company's prospects.

Sell-Side Due Diligence:

While financial due diligence is commonly associated with the buy-side of M&A transactions, it is equally essential for the sell-side to conduct their due diligence. Sellers should consider what information the potential buyers would seek during due diligence. By proactively addressing potential concerns and presenting a transparent financial picture, sellers can enhance their credibility and increase the chances of a successful transaction. The sell-side due diligence involves preparing comprehensive financial reports, identifying value drivers, and addressing any potential deal breakers that may arise during the buyer's due diligence process.

Types of Financial Analysis:

The financial analysis encompasses two main approaches: fundamental analysis and technical analysis. Let's explore each of these in detail.

Fundamental Analysis:

Fundamental analysis involves using ratios and other financial metrics from the company's financial statements to determine its value. By assessing factors such as earnings per share (EPS) and reviewing economic and financial conditions surrounding the company, analysts can arrive at an intrinsic value for the company's equity. The primary objective is to compare this value with the current share price to determine whether the company is undervalued or overvalued.

Critical Ratios Used in Fundamental Analysis:

1. Growth Ratios: These ratios measure the rate at which a company or its business grows. Examples include Revenues Growth, Gross Merchandise Value Compound Annual Growth Rate (GMV CAGR), Annual Run Rate, and Monthly Recurring Revenue (MRR). These ratios provide insights into the company's ability to generate sustainable growth over time.
2. Profitability Ratios: Profitability ratios assess a company's ability to generate earnings relative to its revenue, costs, assets, and equity. Examples include Gross Profit Margin, Earnings Before Interest and Taxes (EBIT) Margin, Return on Sales, Return on Assets, Return on Equity, EBITDA Margin, and Earnings Per Share (EPS). These ratios help determine the company's efficiency, profitability, and ability to generate returns for investors.
3. Leverage Ratios: These ratios evaluate a company's ability to meet its financial obligations and the mix of operating expenses. Examples include Liabilities/Equity, Debt/Equity, Debt/Assets, Debt/Total Capital, EBITDA/Debt, and Free Cash Flow/Debt. Leverage ratios provide insights into the company's financial risk, debt levels, and capacity to manage its financial obligations.
4. Liquidity Ratios: Liquidity ratios assess a company's ability to meet its short-term debt obligations without raising external capital. Examples include the Current Ratio, Quick Ratio, and Cash Ratio. These ratios help determine the company's short-term liquidity position and ability to cover immediate financial obligations.
5. Valuation Ratios: Valuation ratios measure how appropriately shares in a company are valued and what type of return an investor may expect. Examples include the Price/Earnings (P/E) Ratio, Enterprise Value/EBITDA (EV/EBITDA) Ratio, Revenue Exit Multiple, and EBITDA Multiple. These ratios provide insights into the company's valuation relative to its financial performance and industry peers.

Technical Analysis:

Technical analysis uses statistical trends from the company's market, such as moving averages (MA). This type of analysis is relevant to traded stocks and listed securities. Technical analysts believe a security's price reflects all publicly available information and focuses on the statistical analysis of price movements. Technical analysis attempts to understand market sentiment and predict future price movements by studying patterns and trends in price charts and market indicators.

Conclusion:

Financial analysis is a critical component of due diligence in M&A transactions. By conducting comprehensive financial due diligence, investors can gain valuable insights into the target company's financial performance, prospects, and potential risks. Fundamental analysis helps assess the company's intrinsic value, while technical analysis provides insights into market sentiment and price trends. By leveraging these analytical approaches, startups and entrepreneurs can make informed decisions during M&A transactions, ensuring a higher likelihood of successful deals and long-term business growth.