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By Tracy J. Stringer

Thinking of growing your business by buying another company? To enhance core operations or develop new revenue sources, acquisition may be the way to go, but only if you can justify the purchase as more beneficial than reinvesting back into your existing business.

Adopting a growth by acquisition strategy is generally reserved for organizations that have reached a level of maturity that produces a stable and predictable cash flow with consistent earnings. It begins with a straightforward appraisal of the financial health, wherewithal and capacity of your organization to absorb another company with minimal disruption to both businesses. It also entails careful planning throughout all phases of the acquisition process: the purchase, the integration and the growth stages.

The financial health of your company will determine its capacity for an acquisition. Not only must your company be profitable, it must remain profitable in its core business throughout the acquisition and integration process. It's important to set strict parameters up front that quantify what the company can afford.

Each industry and type of business has different metrics to measure financial health, but year-over-year sales and profit growth are a given for all. The business should have a history of improving free cash flow (FCF) and expanding cash reserves. Having a FCF-to-operating-cashflow (OCF) ratio higher than 50 percent and preferably closer to 70 percent demonstrates strong capacity for new investments.

Your quick ratio (QR) and debt service coverage ratio (DSCR) should both be above two to curtail risks of a cash flow crunch. Cash reserves should exceed three-quarters of operating expenses, at a minimum. It is also wise to boost credit lines to twice the cash reserve level, beforehand.

In addition to pure financial strength, an acquiring company should have the management capacity to run a larger entity. While some of the talent can come from the target business, the ultimate management team needs to have breadth of expertise, depth and experience.

A strategic acquisition should bring both tangible and intangible benefits to the business more quickly and economically than can be gained organically through reinvestment. The acquisition needs to grow future profits by either boosting revenues, cutting relative expenses or doing both. Some ways an acquisition can improve revenue and gross margins include opening new markets, adding new customers or gaining access to new products. An acquisition can reduce expenses through synergies, such as the consolidating of administrative and marketing departments and office and warehouse space. Other areas of expense saving might include improved pricing power with suppliers or technology improvements. A combined entity also has the capacity to refinance debt at lower rates.

Don’t overlook the value of intangibles that can impact operations. Conventional intangibles include intellectual property (IP), trademarks, patents, copyrights, brand reputation and goodwill. Digital assets can include websites, email lists, mobile apps, blogs and social media followers. Social media, digital traffic and data analytics can be future growth drivers.

As mentioned, your pool of potential acquisition targets will be defined by your financial capacity. Ideal candidates are companies which can be immediately accretive to earnings. Targets which have strong FCF are preferred but will command a larger premium. A “rule of thumb,” to keep acquisitions manageable, is to limit them to no more than 20 percent of your current business's size. That said, there will always be prudent exceptions. Larger acquisitions should be justified by compelling benefits, such as extraordinary alignment in products or clients which drive higher gross profit margins or operational synergies which drive exceptional cost savings.

As with any business growth strategy, working with an experienced business banker who understands your industry, market and business objectives is critical for success.  A banker with expertise, capital and flexibility can accommodate your organization's lending, expansion and acquisition needs and help you navigate financing options to successfully grow your business.

Tracy J. Stringer is Business Banking Sales Leader for KeyBank in Southwestern and Central Ohio. He can be reached at 513-830-1035 and tracy_j_stringer@keybank.com.

Featured image at top: Austin Distel/Unsplash