Mergers and acquisitions (M&A), such as those facilitated by Oasis in business and sales acquisitions, involve scrutinising several vital factors to guarantee a successful transaction. We will examine the importance of financial analysis during the due diligence process, focusing on two primary methods: fundamental and technical analysis. These concepts are crucial for startups and entrepreneurs to understand, as they provide deep insights into their businesses’ financial health and future prospects.

Importance of Due Diligence in M&A

Due diligence is essential in M&A deals, as it enables the acquiring company to collect important information about the acquired company. This thorough examination covers legal, financial, technical, and commercial elements, with economic analysis being vital. More on this can be found in our article on 9 Key Business Advice for Australian Enterprises.

Financial Due Diligence Explained

Financial due diligence involves a detailed investigation into a company’s financial status and future outlook. Often performed by external experts such as those at Oasis focusing on strategic board consultancy and advice, this analysis serves multiple purposes:

• In-depth Financial Overview: It offers a detailed view of the target company’s financial condition and potential for growth. By analysing financial records, trends, and projections, investors get a clear picture of the company’s economic strengths, such as revenue sources, cost structures, profitability, and cash flow.
• Identifying Hidden Problems: This analysis helps uncover issues that may not be obvious from the financial statements alone. Analysts can spot irregularities, risks, and other factors affecting the company’s performance by closely examining the economic data. This includes evaluating the quality of earnings, potential liabilities, the effectiveness of internal controls, and any possible legal or regulatory concerns.
• Validating the Business Plan and Metrics: Part of financial due diligence is to confirm the accuracy of the target company’s business plan and valuation metrics. This involves assessing the sustainability and credibility of the assumptions and forecasts in the business plan rather than just depending on past performance. A thorough review of financial models, market analysis, and growth forecasts helps investors evaluate the feasibility of the company’s prospects.

Further insights on this topic can be explored in Specialised Business Investment Strategies for Growth.

Sell-Side Due Diligence

While financial due diligence is typically associated with buyers in M&A transactions, it is equally crucial for sellers to engage in this process. Sellers must anticipate the information potential buyers will scrutinise during their due diligence. By proactively addressing any concerns and offering a clear financial overview, sellers can bolster their credibility and improve the likelihood of a successful deal. Sell-side due diligence includes:

• Creating detailed financial reports.
• Pinpointing key value drivers.
• Resolving any potential issues that might emerge during the buyer’s evaluation.

More on this can be accessed through our detailed page on Mergers and Acquisitions.

Approaches to Financial Analysis

Financial analysis involves two primary methods: fundamental analysis and technical analysis. Here’s a closer look at each:

Fundamental Analysis

This method utilises financial ratios and metrics from the company’s financial statements to assess its value. Analysts evaluate various factors, such as earnings per share (EPS) and the broader economic and financial context, to determine the company’s intrinsic value. The goal is to compare this inherent value with the current market price to ascertain if the company is under or overvalued.

Key Ratios in Fundamental Analysis

1. Growth Ratios: These ratios track the growth pace of a company or its business units, with examples including Revenue Growth, Gross Merchandise Value Compound Annual Growth Rate (GMV CAGR), Annual Run Rate, and Monthly Recurring Revenue (MRR). They shed light on the company’s potential for sustainable growth.
2. Profitability Ratios: These ratios measure a company’s ability to generate profits from its revenue, costs, assets, and equity. Typical examples are Gross Profit Margin, EBIT Margin, Return on Sales, Return on Assets, Return on Equity, EBITDA Margin, and Earnings Per Share (EPS). They help assess the company’s operational efficiency and profitability.
3. Leverage Ratios: These ratios examine the company’s capability to meet financial obligations and the balance of operating expenses, including Liabilities/Equity, Debt/Equity, Debt/Assets, Debt/Total Capital, EBITDA/Debt, and Free Cash Flow/Debt. They provide insights into the company’s financial risk and debt management.
4. Liquidity Ratios: These ratios evaluate the company’s ability to cover short-term debts without additional capital. Examples include the Current Ratio, Quick Ratio, and Cash Ratio. They are crucial for assessing the company’s short-term financial health.
5. Valuation Ratios: These ratios assess how the market values the company’s shares and the potential returns for investors. They include the Price/Earnings (P/E) Ratio, the Enterprise Value/EBITDA (EV/EBITDA) Ratio, the Revenue Exit Multiple, and the EBITDA Multiple. These ratios help gauge the company’s market valuation compared to its financial performance and industry standards.

Technical Analysis

Technical analysis relies on statistical trends from a company’s market data, such as moving averages (MA). It is particularly applicable to traded stocks and listed securities. Technical analysts believe that a security’s price already includes all publicly accessible information and primarily focuses on the statistical analysis of price movements. Technical analysis aims to decipher market sentiment and forecast future price trends by examining patterns and trends in price charts and market data.

Conclusion

Financial analysis is essential in the due diligence process of M&A transactions. Through thorough financial due diligence, investors can uncover critical insights about the target company’s financial health, prospects, and potential risks. Fundamental analysis is used to evaluate a company’s intrinsic value, whereas technical analysis offers perspectives on market trends and price behaviours. These analytical methods enable startups and entrepreneurs to make well-informed decisions during M&A activities, increasing the chances of successful acquisitions and sustainable business growth.