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Financial ratios are calculations that provide insights into a company’s performance, profitability, and financial health. They are derived from quantitative data in a company’s financial statements, including the balance sheet, income statement, and cash flow statement.
Financial ratios are used by internal and external stakeholders for various purposes, such as measuring return on capital investments, calculating profit margins, assessing a company’s efficiency, determining debt levels, identifying trends in profitability, managing working capital, and performing market analysis.
Some financial ratios used in M&A transactions include:
1. Growth Ratios
These ratios measure the rate at which a company or its business grows, providing insights into the company’s ability to generate sustainable growth over time. Examples include Revenues Growth, Gross Merchandise Value Compound Annual Growth Rate (GMV CAGR), Annual Run Rate, and Monthly Recurring Revenue (MRR).
2. Profitability Ratios
Profitability ratios assess a company’s ability to generate earnings relative to its revenue, costs, assets, and equity. Examples include Gross Profit Margin, Earnings Before Interest and Taxes (EBIT) Margin, Return on Sales, Return on Assets (ROA), Return on Equity (ROE), EBITDA Margin, and Earnings Per Share (EPS). These ratios help determine the company’s efficiency, profitability, and ability to generate returns for investors.
3. Leverage Ratios
These ratios evaluate a company’s ability to meet its financial obligations and the mix of operating expenses. Examples include Liabilities/Equity, Debt/Equity, Debt/Assets, Debt/Total Capital, EBITDA/Debt, and Free Cash Flow/Debt. Leverage ratios provide insights into the company’s financial risk, debt levels, and capacity to manage its financial obligations.
4. Liquidity Ratios
Liquidity ratios assess a company’s ability to meet its short-term debt obligations without raising external capital. Examples include the Current Ratio, Quick Ratio, and Cash Ratio. These ratios help determine the company’s short-term liquidity position and ability to cover immediate financial obligations.
5. Valuation Ratios
Valuation ratios measure how appropriately shares in a company are valued and what type of return an investor may expect. Examples include the Price/Earnings (P/E) Ratio, Enterprise Value/EBITDA (EV/EBITDA) Ratio, Revenue Exit Multiple, and EBITDA Multiple. These ratios provide insights into the company’s valuation relative to its financial performance and industry peers.
These financial ratios play a crucial role in M&A transactions by providing valuable insights into a company’s financial performance, prospects, and potential risks. By analyzing these ratios, investors can make informed decisions during M&A transactions, ensuring a higher likelihood of successful deals and long-term business growth.
Continue reading: What is EBITDA and how does it affect valuation of a business ?