M&A Fundamentals – Understanding the Balance Sheet from an M&A Perspective
The balance sheet is a statement of the net “book” worth of a company at the date the accounts are prepared. The word “book” is important for the purpose of mergers and acquisitions. The balance sheet may include assets recorded at historic cost that are now worth less, or sometimes more, than their value in the accounts. There are also many things of high value to the acquirer of a company in a mergers and acquisition transaction that do not appear in the company’s books. Such items might include a patent fundamental to the company’s operation or a powerful brand familiar to all the customers in the M&A target’s market. Collectively these items are known in M&A as “Goodwill” but in most circumstances they do not appear in the M&A target’s accounts. We will look at Goodwill in more detail in a later article in our business valuation series.
For the non-financial professional involved in mergers and acquisitions the balance sheet can be seen as a straightforward calculation:
What the Company Owns – What the Company Owes = Stockholder’s Property
Financial professionals express this as the “The Accounting Equation”:
Assets – Liabilities = Capital + Reserves
You can see this equation clearly in the summary balance sheet layout below.
The balance sheet shows the outcome of one of the most important concepts in accounting. A concept that is also of importance to M&A professionals. This concept states that the net assets of the company must be equal to the original equity capital paid in by the owners, plus the net income they have accumulated in the company (represented as profit reserves). Net income in this case is profits after tax, interest payments and dividends distributed to shareholders.
Let’s take a look at each of the main elements of the balance sheet in turn with specific emphasis on issues that are of particular relevance to the executive engaged in mergers and acquisitions.
These are sometimes known as “Tangible Assets” as they are assets with physical form. They include amongst other things land & buildings, plant & machinery, fixtures and fittings.
These assets are recorded at their original purchase price, but this value is reduced each accounting period by a depreciation charge against profit for the M&A targets use of the assets.
Most companies charge the same amount of depreciation against an asset each period. They intend to reduce the net book value of the asset to zero at the end of its expected useful life. This create a problem for M&A professionals involved in an M&A asset transaction (this term is explained in a later article) as the market value of the asset at any point in time might be more or less than the book value at the proposed date of the M&A transaction.
These are assets without physical form. Not all such assets are recoded in the balance sheet. The most common intangible assets you will see in a balance sheet are goodwill from a previous acquisition or accumulated development costs for a commercial project.
Goodwill on acquisition is the difference between the price paid for a company in an M&A transaction and the market value of its net assets at the acquisition date. Under some accounting standards this value can be depreciated (amortised) over an extended period. Goodwill might also be subject to a one-off right down against profit, known as an impairment, if the company acquired in an M&A transaction performs below expectations.
An intangible asset for development costs can be created if the target company in an M&A transaction is working on a development project for a new product or service. Cost for the project will be accumulated in the balance sheet and then amortised over the life of the new product or service when it goes on sale. These types of assets are becoming a much larger proportion of the balance sheet for many companies as economies move away from traditional asset intensive manufacturing. In an M&A transaction for a technology company the new product or service asset might be the main motivation for acquiring the company. The M&A team will need to make a commercial judgement about the likely success of the project. The M&A team might also assess if they could develop the asset in a reasonable timeframe at a lower cost than the seller’s price expectation for the M&A target.
LONG TERM INVESTMENTS
These are usually long-term minority stakes in other companies held primarily for investment purposes. On occasions these minority stakes turn into the platform for a future M&A transaction.
For a manufacturing company this might include raw materials, finished goods and work in progress. Just to confuse matters in UK accounting inventory is often referred to as stock. Although there may be questions about the quality, or even the basis of valuation, for inventory in M&A due diligence, it is relatively unusual for this to be a material factor in M&A negotiations.
This includes money owed by customers, prepaid items and contractual amounts to be received within a year. Those difficult people in the UK often refer to receivables as debtors.
SHORT TERM INVESTMENTS
These are typically held as part of treasury operations rather than as strategic holdings. They might include cash held for example in money market funds or short-term bank deposits.
This is typically positive balances held in current or checking accounts and for some retail businesses notes and coins yet be banked. M&A offers are typically made “free of cash and debt” which means that the existing owners get to keep any positive cash balances. We will examine this in an upcoming article on M&A deal structures.
TRADE PAYABLES & ACCRUALS
These are amounts owed to suppliers. In the UK they are often referred to as creditors.
These are usually corporate income taxes, sales taxes or VAT and payroll taxes deducted from employees. In most M&A transactions corporate income taxes up to the date of closing are payable by the seller. For this reason, they are typically excluded from definitions of net assets where this value is a variable in the calculation of consideration.
BANK OVERDRAFTS & SHORT-TERM DEBTS
This category relates to finance debt that is actually or potentially repayable within a year. Bank overdrafts and invoice finance fall within this definition, but also short-term corporate bonds issued by the company. Term loans, hire purchase agreements and finance leases which will be repaid within the next 12 months are also included.
This balance sheet category is, from the perspective of an M&A transaction, also impacted by the “free of cash and debt” concept. If there are any positive cash balances at closing, they will initially be used to pay off any outstanding long or short-term finance debt. If there is insufficient cash to repay finance debt in full, part of the consideration will be used to settle the outstanding balance.
LONG TERM LIABILITIES
The balances included in this section ate bank loans, mortgages, and debentures with repayment terms longer than one year.
This balance sheet category, from the perspective of an M&A transaction, is also impacted by the “free of cash and debt” concept.
PROVISION FOR LIABILITIES & CHARGES
These are items of future liability that cannot be fully quantified or assigned a specific date of payment, but nevertheless are future obligations of the company. The most common of these are deferred tax reserves, but they might also be for example a reserve to settle outstanding litigation, or a regulatory liability.
These are items that will receive a lot of attention in M&A due diligence. M&A buyers will try and estimate the liability with as much certainty as possible. They might also seek legally binding promises from the sellers to settle amounts in excess of these provisions.
CALLED UP STOCK
This is the face value of the issued and fully paid-up stock (UK Shares) not the market value of the stock or the amount actually paid.
STOCK PREMIUM ACCOUNT RESERVE
The excess paid over the nominal face value paid for issued and fully paid-up stock.
Companies can periodically revalue all tangible and intangible assets (except goodwill). The increase in value is shown as a reserve as it cannot be paid to shareholders unless the asset is sold.
Usually retained income set aside for a specific purpose such as the future repayment of share capital.
INCOME ACCOUNT RESERVE
The total of all income since incorporation that has not been paid to the shareholders as dividends.
About The Merger Training Institute
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Our short, intense M&A courses are designed for executives needing to understand best M&A practice or adding new M&A responsibilities to their existing roles.
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Our Mergers and Acquisitions Training Courses
Core Mergers and Acquisitions Skills Training Course
The Core Mergers and Acquisitions Skills programme (M&A training course) is a three- day programme that teaches all the commercial and technical skills you will need to confidently lead or support a successful M&A transaction.
Our expert tutors guide you through the M&A process from strategy and deal origination to valuation, due diligence, deal structuring, contract negotiation and post-merger integration.
M&A Due Diligence Training Course
The M&A Due Diligence Training Course is a two-day programme that offering a solid grounding in the techniques used by some of the world’s most successful companies to assess risks, evaluate synergies and confirm the strategic fit of an M&A target. The course is designed specifically for executives involved in corporate M&A.
Successful Post-Merger Integration Training Course
The Successful Post-Merger Integration Training Course is a two-day programme that provides a solid grounding in the post-merger integration techniques used by some of the world’s most successful companies to deliver value from their M&A transactions.
Across the two days of the course you move from the key decisions made in the pre-deal phase, through the critical first 100 days and on to full synergy delivery. The course covers the post-merger integration issues most likely to arise in each business function and the most important business processes.
Advanced Business Valuation Training Course
The Advanced Business Valuation training course is a two-day expert level business valuation training course that teaches participants how to prepare robust business valuations in the context of a corporate M&A transaction.
Our expert tutors move you past the stage of plugging numbers into a standard spreadsheet and help you explore how risk, synergies and the quality of the target company might impact its value.