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M&A Fundamentals – Understanding The Cash Flow Statement from an M&A Perspective

Cash flow is an important concept for M&A.  Many of the M&A models used to compare and value companies are based on the potential future cash flows that will be generated by owing the target of the M&A transaction.

 

 

Cash flow through a company is the consequence of three different types of activity:

OPERATING ACTIVITIES

This includes revenue producing activities such sales and production costs, tax, and interest payments.

INVESTING ACTIVITIES

For example, the acquisition and disposal of long-term assets such as land and building or minority stakes in other companies.

FINANCING ACTIVITIES

These are changes to borrowing or equity structures including distributing income to owners by the payment of dividends.

 

In general, for the purpose of M&A analysis we are interested in operating activities and investing activities.  The outcomes of operating activities appear in the income statement.  One of the inputs to M&A target valuations using discounted cash flow methodologies is operating income after tax.  Note that outgoing interest payments are not included in this calculation as for the purposes of M&A investment they are flows to one of the providers of capital to the business, and this provider will typically be paid off from the consideration when the M&A transaction closes.  This means they will leave the capital structure of the M&A target.

Investing activities are usually new or replacement physical assets for the growth of the M&A target, investment projects to develop new intellectual property for the business, or changes in working capital such as increases in inventory and accounts receivable as the business grows. These changes will appear in the historic and projected balance sheets of the target.

Financing activities are associate with providers of debt and equity capital to the business.  The purpose of M&A is to buy out the existing equity owners of the M&A target.  M&A in its very essence is a change of ownership control transaction.  Perhaps less obvious to the non-M&A professional is that providers of debt are in essence owners of the assets in the business against which the loans they provide are secured.  Consequently, the remaining principal of the debt is usually paid out of the consideration at the closing of an M&A transaction, and the equity owners paid the balance of the consideration for their stock.

Income and cash flow are closely related concepts.  From an M&A valuation perspective perhaps the best way to understand the interaction of the two is through this equation:

Cash Flow = Income after tax from operating activities +/- Balance sheet changes from investment activities

Accountants and M&A professionals reconcile income to cash flow as follows:

 

Diagram1:  Income and Cash Flow Reconciliation

 

In this reconciliation depreciation and amortization charges to the income statement are added.  This is because they have no impact on cash flow.  The cash flow impact occurred when the asset was purchased and was reflected in the balance sheet at that date.  Accounting procedures make a bookkeeping entry each year to reflect that a fixed asset will be used up over time called depreciation.  Similarly purchased goodwill (from an M&A transaction) under some accounting conventions will be amortized over an extended period to reflect that goodwill in a company may not have an indefinite life. Neither of these bookkeeping adjustments have a cash flow impact and so can be ignored in M&A discounted cash flow valuation models.

Similarly, any revaluations of provisions or reserves that result in an income statement adjustment but have no associated cash movement are also adjusted.  A good example might be a revaluation of real estate or an adjustment to an inventory provision.

 

The reconciliation brings us to one of the most important concepts in M&A valuation using discounted cash-flow methodologies.   The concept of Free Cash Flow.  The discounted cash flow M&A models used to compare and value companies are based on potential future free cash flows.  Free cash flows in M&A valuation are cash flows that are available for distribution to providers of debt or equity.

To arrive at free cash flow the M&A professional will make an adjustment to net cash flow from operating activities if the company that is the target of the M&A transaction needs to make regular cash investments to sustain or grow its income.  An example might be a mobile phone infrastructure provider that needs to expand network coverage within its territory to add more customers.  A buyer that acquires this company in an M&A transaction would have to plough a significant proportion of operating income back into the company each year reducing the cash flow it has free to distribute to shareholders.

There are two forms of the free cash flow calculation.

FREE CASH FLOW TO THE ENTERPRISE or FIRM (FCFF)

This calculates cash flow available to all providers of capital (equity and debt).  The calculation is:

Net Cash from Operating Activities

Minus: Capital Expenditure

Plus:   Interest payments

FREE CASH FLOW TO EQUITY

This Includes only the cash flows available for distribution to shareholders (equity). The calculation is:

Net Cash from Operating Activities

Minus: Capital Expenditure

Minus: Dividends on Preference Shares.

 

The importance of Free Cash Flow in M&A will become apparent as we work through subsequent articles on capital structure, enterprise value and the various company valuation approaches used by M&A professionals.

 

About The Merger Training Institute

We provide practical, in-career mergers and acquisitions training for boards, executives and professionals in global corporations.

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.

The courses are taught by tutors with hands-on M&A experience gained as part of corporate management teams. As well as being academically rigorous they are rich with case studies and real-world examples based on our tutor’s practical mergers and acquisitions experience.

Our course participants come from a wide range of industries and roles including general management, business development, strategy, marketing, finance, human resources, operations and legal.

 

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.


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M&A Fundamentals – Using the Capital Asset Pricing Model to Calculate Cost of Equity

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