Assessing growth opportunities: are you financial or strategic?

• Author: Molod, Seth
• Position: PRIVATEcompanies - Evaluation of acquisitions and mergers based on analysis of financial statements

Evaluating a potential merger, acquisition or investment opportunity can lead you down an exciting but sometimes perilous path. Some of the best "deals" you make may be the ones you pass on. However, if growth is in your plan, you will no doubt want to consider opportunities.

The due diligence phase of your investigation can help you set a sensible price. First, know what kind of buyer you are: financial or strategic. Financial buyers seek a targeted return on the investment and look to maximize undervalued assets, such as real estate. They usually require exit strategies and timetables for divesting. Strategic buyers search for synergies with their business, valuable employees, relationships or some mixture of these.

The would-be seller will provide potential buyers with masses of information highlighted by the company's financial statements. When looking at the income statement, be sure to calculate EBITDA (earnings before interest, taxes, depreciation and amortization). This gives you a measure of profitability without regard to things likely to change after the acquisition, such as the company's debt structure, its tax status and fixed asset base. EBITDA also lets you compare profitability within the industry.

Perform some ratio analyses on the financial statements, looking for both trends and industry relationships, such as:

* The current ratio. Current assets divided by current liabilities. It should be 1.0 or above; 2 or above is very good. If it's below 1, look deeper.

* Working capital. Current assets less current liabilities gives you working capital.

* Net sales to accounts receivable, which indicates how long it takes to convert receivables into cash.

* Inventory turnover ratio. Divide the cost of goods by average inventory to see how long it takes to sell inventory.

* Debt to equity. Divide shareholders' equity into long-term debt to see a company's leverage and ability to borrow.

* Debt service coverage ratio, which is EBITDA divided by annual principal and interest payments.

Read the notes to the financial statements and the auditor's opinion. You'll see whether the auditors have issued a clean opinion and whether there are any issues about the enterprise's viability. Also, look for other important information in the notes in these areas:

* Related Party Transactions. Any non-arms-length transactions? If so, they should be addressed in the negotiations.

* Off Balance Sheet Obligations. Hidden liabilities and long-term...