For some, finance and accounting can be tedious subjects: complex and hard to understand. Even so, it's essential to have a basic grasp of them to understand in depth how a company works, analyze its potential and what can be improved, and value your business properly so you know what to expect from an investor.
That's why, to simplify things a little and bring some transparency, in today's article we explain in a simple, concise way five concepts we think every business owner should know, particularly when facing the sale of their company or, more generally, any M&A process.
The 5 key concepts in M&A
These concepts matter when it comes to finding the best deal because, to know whether an offer matches what we're offering and what we can expect for our company, we need to understand which relevant variables investors will look at when analyzing the company, how those variables are calculated, and how important they are.
EBITDA
The name is an acronym for earnings before interest, taxes, depreciation, and amortization, that is, profit before interest, taxes, depreciation, and amortization. It's a widely used way to measure the company's operating income, in other words, the profitability of the business. It's calculated by subtracting from all of the company's operating revenue – the revenue from its core activity (sales or net revenue) – the expenses needed to generate it (supplies, personnel costs, and other operating costs). It's an initial measure that, because it excludes (financial) income and expenses (financial expenses, taxes, depreciation, and amortization) not directly related to the core business model, reflects the result the company obtains from its core activity over a specific period, usually a calendar year, and it's very useful for comparing different companies. Even so, it's important to consider how it has been calculated, that is, what has been recorded as an expense and as income, and, to make it truly representative, certain corrections can be made to obtain an adjusted EBITDA that more faithfully reflects the company's reality.
Gross margin
This is a first indicator of the company's profitability, obtained from the difference between operating revenue - sales or net revenue - and production expenses – the costs directly related to the product, supplies, or COGS (cost of goods sold) -. It can also be calculated as a percentage, by dividing the difference between sales and supplies by sales. It's a first measure of profitability, used to assess the viability of the business model and the level of costs being incurred to generate the company's revenue.
Free cash flow
Also known as free cash flow (FCF), this is a measure of the cash the company generates; that is, the money left from all receipts after deducting all payments. It differs from other accounting metrics because it reflects the money that has actually come into and gone out of the company's coffers, the so-called cash flows, and it measures the company's ability to generate cash relative to its obligations, the payments it has to make. It's calculated by taking net profit, adding the costs that don't involve a cash outflow (amortization, depreciation, and provisions), and subtracting the expenses and cash outflows that aren't reflected in the income statement (investment in operating working capital and investment in fixed or operating assets, also called CAPEX).
Leverage
Financial leverage refers to using debt or other financing instruments to fund part of a deal, so that the capital deployed is greater than the equity contributed to the transaction. This makes it possible, for example, to have twice the resources to buy a company. It's usually expressed as a fraction or a percentage, that is, as a ratio representing the relationship between equity and the total resources used in the deal (1:2 or 50% means that half of the capital comes from equity and the other half of the resources in a deal is financed).
Working capital
Known in Spanish as fondo de maniobra, this is a fundamental ratio for measuring the relationship between the company's most liquid resources, which can be converted into cash most easily and are reflected in current assets (from receivables due in less than a year to money in bank accounts), and its short-term obligations, due in less than a year, reflected in current liabilities. Through this measure, the difference between current assets and current liabilities, you can see that part of current assets is financed with long-term debt, and it's a very useful metric for analyzing a company's short-term solvency and liquidity, that is, its ability to meet its short-term obligations. We hope these explanations have shed some light on finance and accounting, key knowledge for succeeding in any M&A deal or business sale. Although the information and the theoretical measures and valuations that can be made of a company are key when facing any corporate transaction, there's no better way to find out a business's real value than going to market, that is, starting to connect with investors.
