IB Pitchbook – Liquidity Analysis

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Liquidity Analysis

An analysis of a company’s liquidity is important because it gives us insight into its capacity to pursue an M&A transaction. We need to identify trends in a company’s liquidity position, what their needs are over time, and the implications to the company’s liquidity if a transaction is to be pursued. When performing a liquidity analysis, the main points to consider are the company’s cash flow profile, capital expenditures, debt, and future funding requirements.

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Cash Flow Profile

The company’s ability to generate cash from operation is the main focus of liquidity analysis. As an investment banker, you must consider any significant trends or shifts in the company’s variable and fixed costs. How is the performance of the company’s margins over time? What inventory costing do they use (LIFO, FIFO, weighted average cost)? What depreciation methods do they use (straight line, declining balance)? How does their financial accounting differ from their tax accounting, and its implications on tax deferral? Are there any major gains and impairments that should be considered?

All of these questions contribute to the overall sustainability of the company’s operations and its overall capacity to pursue a transaction. How much of the transaction can be funded internally? How much additional capital must be raised? What type of capital can be raised and what is the strategic rationale for raising one form of capital over another?

Capital Expenditures

The company’s CapEx schedule is very important when pitching a transaction opportunity because it is the main opportunity cost to consider against a transaction opportunity. For example, a company can invest in its own capital that will replicate the benefit of a transaction. Furthermore, the amount of capital available to a company may already be committed to specific capital requirements, it is an investment banker’s job to calculate the requirement and frame a strategic recommendation around these existing commitments.

When we consider a company’s capital expenditures, it is important to distinguish between growth and maintenance CapEx. While it is critical for a company to continually invest in maintenance CapEx to replace any depreciation, the amount of growth CapEx could be the amount that a company might forgo to pursue a transaction. If M&A is a regular course of business (i.e. AutoCanada, Premium Brands), the growth CapEx may already be factoring in transactions on an ongoing basis.

Debt

The company’s leverage is probably the most important element to consider when pitching a transaction. If we think about accretion/dilution, due diligence lets us choose an appropriate range of stock vs cash breakdown in terms of limits on the amount of leverage a company and its creditors may be comfortable with. Furthermore, taking on too much debt to fund a transaction may cause the company to incur interest beyond what it can pay down. Also, if a company faces any major debt maturities in the near future, it may opt to conserve its dry powder in anticipation of the debt coming due.

A company may include items that behave like debt, and we must consider any operating or financial leases by the company, as well as any pension obligations the company is committed to paying out. Additionally, we must think about how much room the company has in short-term credit facilities, and the company’s capital allocation priorities before pitching a transaction.

If the target company is also leveraged, we must take into consideration the fact that the target’s enterprise value includes the value of its debt. Therefore, it is important to consider the change in a company’s leverage ratios pro forma the transaction.

Additional Resources

Thank you for downloading CFI’s free investment banking pitchbook template. To keep learning and advancing your career, the following resources will be helpful:

• Weighted Average Cost of Capital (WACC)
• Straight Line Depreciation
• Debt Capacity
• Due Diligence
• See all valuation resources