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What is financial synergy in merger and acquisition?
Before going for financial synergy, let us understand the word synergy which is commonly used in merger and acquisition. Synergy can be understood as, the combined value and performance of a merged company is always greater than the value and performance of individual companies (which are merged).
Synergy can be formulated as below −
Value of merged companies > value of individual companies
Let say two companies, X and Y are merged, now synergy can be formulated as
$$\mathrm{Value\:of\:(X+Y)>\:Value\:of\:X\:+\:Vale\:of\:Y}$$
In both, financing activities and operating activities synergies can arise the following −
Financial synergy − Arises from improved efficiency of financial activities (reduction in cost of capital).
Operational synergy − Achieved by improving operational activities (cost reduction from economies of scale).
Financial synergy results in financial advantages of a combined company (after merger) than the companies who are unable to achieve individually (before merger). If two medium sized companies are merged, then they get financial advantage by reducing cost, increase in capital, tax benefits, loan benefits etc.
In this synergy, there will be increase in revenue, debt capacity, profitability etc. To identify the potential financial synergies, both financial and valuation analysts work together.
This synergy provides a secure funding source. If a small or weaker company asks for loans or wants to lend money from the borrower, he may charge high interest rates to compensate for the risk.
If the same company is merged with a larger or financially strong company, the borrower may charge a low interest rate because the risk in giving money is less as compared to the financially weaker company.
Financial synergy benefits
It has both positive benefits and negative benefits
Positive benefits − The benefits in terms of debit capacity (when companies merged their cash flows, earning may become predictable and steady), profitability and in terms of tax (takes advantages current tax law and net operating losses are used to shield income), reduction cost of equity (which is arise from diversification) are increased.
Negative benefits − If the value of merged companies is low when compared to combined value of each company separately.
Overall value (related to expenses and revenue of newly formed companies after merging) is evaluated based on income statements of all companies together. Using income statements, combined profitability is assessed whether it creates positive synergy or not and from the balance sheet, debt capacity is examined. Finally using a cash flow statement, company cash flows are checked (to check if it is positive synergy or not).
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