I’ve been talking quite a bit about how companies can actively increase shareholder value lately.Â One of the ways to increase value to the shareholder is to decrease the company debt.Â Â However, that brings us to another issue that has become more and more common in the past few months.
With all of the merger and acquisition activity happening in the markets lately, valuing the merged entities becomes slightly tricky using regular ratios and metrics.
Consider, for instance, that we use the debt-to-cash-flow ratio as one of our key ratios to determine the general financial health of a company.Â While this metric is commonly used and can be a good indicator to screen out certain companies, it does present a problem when evaluating recently merged entities.
When companies are acquired, the acquiring organization sees their debt rise immediately, while the resulting cash flow comes through the course of the year following the acquisition.
In the interim it is more accurate to use the debt-to-equity ratio in order to make determinations regarding a recently merged organization’s debt situation.Â Once a complete year has passed, we can then assess the resulting cash flows from the acquisition or merger more accurately and once again use the the debt-to-cash flow ratio.
This is just one of the several considerations that should be taken into account when mergers and acquisitions happen.
It is important to take extra precautions and check the numbers thoroughly, especially in M&A situations.