“Ideal” numbers depend on the buyer
Posted by mbbi on March 11, 2011
One of the things that makes the M&A marketplace so unpredictable is that buyers don’t all share the same acquisition criteria. Traditionally, there have been two types of M&A buyers: 1) financial, which look for acquisitions that will produce a return on investment, and 2) strategic, which primarily seek business synergies.
Such broad objectives, as well as industry, size and other factors, influence how buyers evaluate a target company’s numbers. Although certain characteristics have an almost universal appeal — no one is likely to sneeze at 15% annual earnings growth, for example — ideal numbers often are in the eye of the beholder.
Everyone values earnings
Both financial and strategic buyers typically start by looking at a target’s earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA measures the operation’s profitability before the factors that probably will change after the merger — such as debt structure, taxes and the amount of fixed assets it takes to generate sales.
EBITDA also can help buyers compare profitability between acquisitions in the same industry. Caution, however, is warranted because EBITDA isn’t a Generally Accepted Accounting Principle. Buyers must ensure the same assumptions (particularly when it comes to depreciation methods) are used for every company they study.
Current needs
Ratio analysis provides further general information about a target company’s financial performance trends. It’s up to the buyer to interpret these ratios according to its acquisition needs.
For example, the current ratio represents a company’s ability to meet its near-term obligations and is calculated by dividing current assets by current liabilities. The general rule of thumb for a current ratio is 2:1, and a ratio lower than 1.1 is usually considered risky.
A financial buyer might be wary of a low current ratio because it could hamper its ability to realize a short-term return on investment. Strategic buyers may be more forgiving of a lower number if the company has other desirable traits, such as unique products.
Open to interpretation
Another financial ratio that may be open to interpretation is working capital, which represents the company’s ability to carry on business comfortably and expand operations without seeking new financing. Working capital is assessed by subtracting current liabilities from current assets. A positive number is better — unless the buyer is acquiring a distressed company.
Inventory turnover, which shows how long it takes to sell inventory numbers also may be interpreted differently by different types of buyers. This ratio is calculated by dividing the cost of goods sold by average inventory. Inventory turnover is most useful for manufacturing or distribution companies.
Desirable numbers depend on the industry and inventory philosophy. A low number means the company chooses to be fully stocked (has a higher investment in inventory and never misses a sale). A high number means a company is thinly stocked (has a low investment, but could miss sales).
Beyond the numbers
Once financial buyers feel comfortable with the target’s numbers and believe the company offers a more than 10% return on investment, they may be ready to move forward with an acquisition. But strategic buyers typically go a step further and review opportunities for vertical and horizontal integration.
Vertical integration allows a buyer to reduce supply chain expenses, improve access to key services or materials, and leverage resources. Horizontal integration involves gaining new markets for existing products, cross-selling products to existing customers and expanding distribution networks.
Today’s landscape
In the current M&A market, strategic buyers far outnumber financial ones. Such an imbalance could mean that what were considered desirable financial ratios only a few years ago, aren’t now.
