Evaluation of Merger Proposal

A merger is often an excellent way for small businesses to achieve financial and operational growth. Many companies merge to obtain financial synergies, gain market share or improve their leadership team. The first step in evaluating a merger is to analyze financial statements from both companies to ensure that the transaction makes financial sense.

Financial Statements

The first step in evaluating a merger’s financials is to obtain the target company’s financial statements. If both companies are already discussing a merger, each company can sign a non-disclosure agreement and exchange financials.

If you are not yet in the discussion stage, try searching equity analyst reports and news articles for any publicly available information. If you cannot retrieve enough information, interview experts in the field. Major customers, the management of competing companies, or equity analysts that cover similar companies can all provide helpful financial details. Although you probably will not be able to obtain full financial statements via this method, you should be able to get high-level details such as average revenue, expenses, debt and cash flow.

As you analyze the financials of the merger, utilize both the historical and forward-looking financials to see a picture of how the company has performed in the past and how they are expected to perform in the future.

Income Statement

Income statements illustrate the financial profitability of a company. The revenue line of the income statement illustrates the company’s top-line momentum, while the expenses show whether or not the company is using its resources wisely.

Combine both company’s income statements to illustrate the income statement of the combined company. For most items on the income statement, you can use simple addition to combine each company’s financials. Pay special attention to the tax and income expense lines. The tax rate is based on a complex equation of size, tax havens, grants and credits. Meanwhile, income expense is based on debt interest rates. Banks base interest rates on the leverage and liquidity of a given company. Because of the complexities involved in these line items, it is best to consult with an accounting expert to find the correct tax rate and interest rate for the merged company.

If you believe that the merger will result in financial synergies, add these into the merged income statement as a new line item. Synergies can include a variety of things, such as increased revenue from improved market share, decreased overhead costs and decreased headcount-related costs.

If you only have certain items from the income statement, such as sales and expenses, evaluate those line items only. Once you proceed into negotiations with the target company, you can obtain full financial records.

Balance Sheet

The balance sheet shows a company’s major assets, such as land and equipment, and its financial leverage, more commonly known as debt. As with the income statement, you can simply add each company’s balance sheet items to obtain a combined balance sheet. However, the shareholder equity and goodwill line items require very complex calculations. Shareholder equity includes the portion of the company owned by stockholders. If either company has made an acquisition in the past, goodwill will include the excess amount paid for the acquisition over book value. The calculations for these items depends on the type of merger and the book value of each company. Consult with an accounting expert to insure accurate calculations of these items.

If you do not have visibility into the full balance sheet, focus initially on the target company’s debt level and total equity. Most banks calculate a ratio of total debt to total equity when determining loans and interest rates. A debt to equity ratio that is too high could jeopardize your company’s ability to borrow money.

Cash Flow Statement

To analyze the merged cash flow statement, start by adding both company’s statements together. Once this is complete, review any changes you made to the tax rate or interest rate when analyzing the income statement. If these rates changed, be sure to adjust the Tax and Interest Expense to reflect the post-merger rates.

Obtaining a full cash flow statement is not absolutely necessary in the first stages of evaluating a merger. Once you are in negotiations with the target company, be sure to evaluate whether or not the merged company will have enough cash to cover its payments to lenders.

Putting It All Together

Now you have the income statement, balance sheet and cash flow statement for the merged company, or at least a general idea of what your revenue and expenses will look like. The first thing to look at is the combined profitability from the income statement. Is the merged company more profitable than each company on its own? Will the merger improve both company’s growth and trajectory?

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