5. Funding the Proposed Transaction

Overview

In this lesson, we examine the likely sources of funds that the acquirer will use to fund the transaction. This requires us to review the balance sheet of both the acquirer and the target

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Summary

  1. Lesson Goal (00:04)

    The goal of this lesson is to learn how ShirtShop can fund the proposed M&A transaction.

  2. Analyzing Both Balance Sheets (00:22)

    There are three methods that an acquirer can use to fund an M&A transaction: cash, debt, or shares. Cash can come from the Balance Sheet of the acquirer or the target. Debt can be issued by a bank, however they are unlikely to issue debt if the acquirer already has a large amount of debt on the Balance Sheet. Finally, new equity can be issued to complete a transaction. Many transactions will feature some combination of these three funding methods.

    In our example, the acquirer, ShirtShop, has a positive but small cash balance. They have little debt, so they could fund the transaction using debt. However, the target, TrouserTown, has a very large and growing cash balance. They also have little debt on their Balance Sheet. It’s possible that ShirtShop could use some or all of TrouserTown’s cash pile to partly fund the transaction, in combination with debt and equity.

  3. Analyzing the Target’s Income Statement (02:21)

    Analyzing the Balance Sheet can provide clues as to any differences in the financial health of the two companies in the transaction. To determine why these differences arise, we can analyze the Income Statement, and in particular the profit margins. In our case, we find that TrouserTime has a net profit margin and EBITDA margin roughly double the values for ShirtShop. This could explain why TrouserTime is in a better position than ShirtShop. It also tells us that TrouserTime may possess operational capabilities that could be of value to ShirtShop.

Transcript

In the previous lesson, we examined the acquirer ShirtShop's income statement and realized that revenue wasn't growing fast enough to please investors. And at the same, the profit margins, both at net profit and EBITDA level, were also lagging behind the industry. Now we're going to move on to the balance sheet because all I want to understand from the balance sheet are the current resources available to ShirtShop. When funding M&A transactions, acquirers have three tools at their disposal: cash, debt or shares.

Cash will exist on the balance sheet and here I can see that the company only has 59.1 million as of the end of 2016.

Obviously, this isn't going to go very far in buying a company for a billion. Let's now take a look at the debt position. If it turns out that ShirtShop has a lot of debt, there's no way that this deal would get done outside of shares because a bank won't want to give ShirtShop any debt when it has so little cash on the balance sheet. Thankfully, when we look at total debt, we can see that it's actually half of cash. So the net debt position of this company is positive.

The cash in question to do a deal does not just relate to the cash on the acquirer's balance sheet, it can also involve the cash on the target's balance sheet.

When I take a look at the balance sheet of the target, we can see a very different story. TrouserTown actually has buckets of cash on the balance sheet. It tends to grow pretty consistently every year.

And I'm wondering if ShirtShop intends to use this cash to fund part of the transaction. If it did, it would have a sizeable portion of the total fee ready in cash. But either way, it looks like a combination of shares and debt along with some cash will be needed to complete this transaction.

Similar to ShirtShop, TrouserTown also has very little debt on its balance sheet. Although the company is a lot smaller, it appears that the company is in much better financial health.

Let's take a quick look at their income statement to see why this might be the case. And as we can see, the margins are much higher in TrouserTown than they are for ShirtShop. You might remember that ShirtShop was struggling to hit a net profit margin of greater than 5%, whereas TrouserTown is trouncing this figure. Although TrouserTown is growing very slowly, it's maintaining a very healthy level of profitability. And in addition, the EBITDA margin is almost double the EBITDA margin that ShirtShop can achieve in its business.

As an analyst, I'm beginning to think that some of the operational capability within TrouserTown could definitely benefit ShirtShop, especially when keeping costs under control.

We'll explore this dynamic in the next lesson when we build out the synergy projections for this particular transaction.