M&A Vocabulary – Understanding the Experts: “Cash Free & Debt Free”

The term Cash Free & Debt Free (short: CFDF) is synonymous with being free of cash and debt and is used worldwide as a purchase price mechanism in corporate transactions due to its clear definition and simple application. But what exactly does applying this CFDF mechanism mean in the context of a transaction?

In principle, a seller would still be entitled to retain all cash and repay all debt until the so-called “closing date” (i.e., the completion date up to which the original owner of the target company is still considered the seller). In transaction practice, however, this usually does not happen (at least not in the context of share deals), as all cash and debt remaining on the balance sheet as of the reporting date are added to or deducted from the so-called Enterprise Value (i.e., the total value of the company as the market value of equity plus the value of debt) in order to determine the final purchase price.

Specifically, the purchase price is usually composed as follows: (i) the Enterprise Value (EV), which is defined in the Share Purchase Agreement (SPA) and results from the valuation of the company, plus (ii) the amount of cash and cash equivalents, minus (iii) financial debt or debt-like items, plus/minus (iv) other purchase price adjustments agreed between the parties (e.g., differences in the level of working capital, i.e., net current assets between the average level specified in the SPA and the actual level in the closing balance sheet).

The following sections briefly explain points (i) to (iii) mentioned above to illustrate how the CFDF mechanism works and its specific significance.

Enterprise Value (EV)

Enterprise value refers to the market value of all of a company’s capital sources (i.e., the market value of debt, common stock, and preferred equity minus liquid assets). There are various methods for determining the total value of a company. In M&A practice, discounted cash flow methods and multiplier methods are the most frequently used. In multiplier methods, EBITDA and EBIT multiples are by far the most commonly used.

EBITDA and EBIT are profitability ratios that are independent of a company’s financing structure. They are therefore suitable for determining the enterprise value of a company.

In an acquisition as a share deal, the shares in the target company are acquired. The value of these shares is represented by the so-called “Equity Value” (market value of equity). To determine this equity value, it is necessary to remove the effect of net financial debt (i.e., (ii) liquid assets minus (iii) financial debt and debt-like items).

Cash and Cash Equivalents

A financing concept can vary depending on the M&A deal and can be designed individually. However, the definition of cash and cash equivalents is usually consistent. The most conservative definition would only consider money in bank accounts (i.e., short-term realizability). Sometimes, however, there are other items on the balance sheet that are to be classified as cash equivalents. These must be analyzed, quantified, and adjusted if necessary as part of a due diligence.

These include:

a) Restricted Cash: Unlike freely available cash that a company has at its disposal to spend or invest, restricted cash refers to cash held for a specific purpose and therefore not available to the company for immediate or general business activities. Most cases relate to bank deposits used as collateral (e.g., court deposits or guarantees for bank loans and other financing). Conceptually, restricted cash should only be classified as a cash equivalent if there is a simultaneous associated liability included as a debt-like item. However, it is crucial to understand the specific characteristics of each individual case and evaluate them accordingly.

b) Petty Cash: Especially in emerging markets where internal controls within a company are often not very sophisticated, this account is sometimes used to record reconciliation differences. In such cases, petty cash should not be considered a cash equivalent.

c) Other examples: Credit card receivables and payments in transit, bank reconciliations, escrow accounts, loans to third parties, etc.

Debt and Debt-like Items

The definition of financial debt and debt-like items in an M&A deal is usually broader than just bank loans and financing. For example, an item can be considered debt or debt-like regardless of whether it is recognized as a liability on the company’s balance sheet or not.

Examples of debt positions and debt-like items include:

a) Loans and financing: The most common example is loans taken out from banks or financial institutions.

b) Long-term provisions: Long-term provisions are usually discounted and therefore do not, or do not fully, reflect the enterprise value. For example, expenses for the future formation of provisions are not included in the valuation-relevant multiplier base. Long-term provisions should therefore be considered a debt-like item (e.g., pension obligations, provisions for partial retirement, anniversary provisions, litigation provisions, or environmental provisions).

c) Debt-like items: There are other examples of debt-like items that should be assessed for both parties in the context of the transaction and which can have a direct impact on the purchase price (e.g., provisions for income taxes; overdue supplier payments; customer prepayments, loans from third parties, investment backlog, or extraordinary liabilities from investments).

d) Specified and non-specified claims: Sufficiently specified burdens (e.g., lawsuits against the company) as well as imminent payment obligations (e.g., non-compliant processes that could lead to a sufficiently specific risk in the future) are also considered debt-like obligations. The specific likelihood of occurrence and the total amount should be assessed by legal advisors.

The following figure provides a brief summary of the practical application of some of the items presented in this article:

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