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When you purchase another company, it is known as an acquisition. You can finance an acquisition through cash or through your company's stock. The advantages of using a cash acquisition are the purchase price will be certain and you will not have to dilute ownership of your company. The disadvantages are you will spend down your cash reserves and have a greater risk of debt problems if the acquisition is financed through loans.
Certain Purchase Price
When you acquire another company using cash, the amount that will be paid is certain. It is a less risky transaction for both companies than a stock acquisition, because cash does not fluctuate in value like stocks do. If you purchase another company with your stock and your share price increases significantly, you will have paid much more in the acquisition than if you had paid in cash. Using a cash acquisition gives the advantage of a guaranteed purchase price over the fluctuating price of stock.
No Dilution of Ownership
Another advantage of using a cash acquisition is it prevents dilution of ownership of your company. If you exchange your company's stock to fund the acquisition of another company, its shareholders will be partial owners of your acquired company. They will be entitled to a percentage of your company's future profits and will have a vote in shareholder decisions. A cash acquisition allows you to maintain the current ownership status of your company, while a stock acquisition does not.
Loss of Liquid Asset
A disadvantage of using a cash acquisition is that you will spend down your cash reserves, your company's most liquid asset. While the fixed assets of an acquired company are expected to give you long-term growth, they will be difficult to convert to cash in the short run. If you run into cash flow problems and need to sell off the acquired company quickly, you will likely receive less than you paid for it. When you use a cash acquisition, make sure your cash flow is stable enough to exchange your cash for the fixed assets of another company.
Potential Debt Problems
A cash acquisition can also result in debt problems if you finance the purchase with bank loans. Increasing the amount of debt your company holds will increase your company's annual interest payments, potentially creating cash flow problems. While you can stop dividend payments to your shareholders if your company needs the cash, you must make your interest payments every year to avoid default. Taking on more debt to acquire a company may make your company seem riskier to lenders, and your debt rating may be decreased by rating agencies.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.