A major investing activity on the cash flow statement representing the cash paid to acquire another company, net of the cash held by the acquired entity.
When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
Purchase of Business, also known as an acquisition, refers to the cash outflow a company makes to acquire another company, business unit, or a controlling interest in another entity. This transaction is a key component of a company’s growth strategy and is reported in the Investing Activities section of the Statement of Cash Flows. Because the company is using its cash to buy a long-term asset (the new business), it is always recorded as a use of cash. This line item is one of the most significant indicators of a company’s strategy for inorganic growth.
Accounting and Financial Statement Presentation
The purchase of a business is classified as an investing activity because it represents a major investment made to generate future economic benefits. It is always a cash outflow and is reported in the investing section, often with a clear label like ‘Acquisitions, net of cash acquired’ or ‘Purchase of business’.
Calculation: Net of Cash Acquired
A crucial accounting rule is that the cash outflow reported on the statement is the purchase price net of any cash held by the acquired company. For example, if Company A buys Company B for 10 million of cash on its balance sheet at the time of the deal, the net cash outflow for Company A is only 10 million in cash immediately upon acquisition.
“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
— Warren Buffett, Chairman & CEO, Berkshire Hathaway Berkshire Hathaway Chairman’s Letter 1985 (1985)
Strategic Reasons for Acquiring Businesses
Companies engage in acquisitions (Mergers & Acquisitions or M&A) for a variety of strategic reasons, all aimed at enhancing long-term value.
- Inorganic Growth: To rapidly increase revenue, market share, and customer base by absorbing a competitor or entering a new market.
- Acquiring Technology or Talent: To gain access to valuable intellectual property, proprietary technology, or skilled employees that would be difficult or time-consuming to develop internally.
- Achieving Synergies: To create value by combining operations, which can lead to cost savings (e.g., eliminating redundant departments) or revenue synergies (e.g., cross-selling products).
- Diversification: To expand into new business lines or geographic regions to reduce reliance on a single market or product.
- Defensive Strategy: To purchase a disruptive startup or competitor to eliminate a potential future threat.
How to Interpret a Significant Business Purchase
A large cash outflow for an acquisition is one of the most significant strategic moves a company can make and requires careful analysis.
Key Considerations for Analysts
- Growth Strategy: It signals a clear strategy of inorganic growth, which can be faster but often riskier than organic growth (investing in one’s own operations).
- Use of Capital: It shows a major deployment of the company’s capital. Analysts will assess whether the purchase was a better use of cash than alternatives like R&D, capital expenditures, or returning cash to shareholders.
- Integration Risk: Large acquisitions come with significant execution risk. Analysts will watch closely in subsequent periods to see if the promised synergies materialize and if the integration is successful.
- Valuation: A key question is whether the company overpaid. Analysts will scrutinize the purchase price relative to the target’s earnings and growth prospects to determine if the deal is likely to create long-term value.
Real-World Examples
Broadcom’s Acquisition of VMware
In 2024, Broadcom finalized its acquisition of VMware for approximately $69 billion. The cash portion of this deal would appear as a massive cash outflow in the investing activities section of Broadcom’s cash flow statement, reflecting one of the largest tech acquisitions in history aimed at diversifying its business into enterprise software.
ExxonMobil’s Acquisition of Pioneer Natural Resources
In 2023, ExxonMobil announced a nearly $60 billion all-stock deal to acquire Pioneer. Since this was an all-stock transaction, it would not appear as a cash outflow in the investing section. However, if a portion of the deal had been paid in cash, that amount (net of cash acquired) would have been reported as a ‘Purchase of Business’.