Due Diligence

Mini Guide to a Financial Due Diligence

Gabriele
·
May 25, 2021

You've just closed a deal and purchased your first company; sales have been brisk for the first six weeks, and you're feeling pretty good.


They suddenly plummet by 30% for no apparent cause. After a closer look, you notice a disturbing number of negative customer feedback from before you bought the business. Customers have been complaining for a long time that the goods are becoming obsolete and dysfunctional, and you might have expected the decline in revenue if you had found these issues earlier.


These kinds of situations can be avoided with sufficient financial due diligence.


It's impossible to avoid closing a bad deal every time, but taking the time to gather the right details will make you feel more at ease before you do.


What Is Due Diligence and How Does It Work?


Due diligence is a term that has been used for a long time becoming a common practice among securities dealers and brokers.


In reality, it was written into the law as a shield for securities dealers who were being unfairly prosecuted.


Financial due diligence, on the other hand, is not for protection brokers. Anyone considering an investment, such as buying a company, should conduct due diligence with the utmost caution.


Due diligence is a review or investigation of a possible acquisition target. In addition to reviewing financial statements, every interested party should make every effort to verify any facts claimed by the seller.


Basically, you want to ensure that there are no surprises after you complete the transaction. Although there are bound to be a few, doing your homework helps you to reduce the risk in the future.


Checklist for Financial Due Diligence

Let's get into the individual things you should be looking at now that you know what due diligence is and why you need to do it. Use the checklist below to help you through the process.


Principles of Accounting

Is the business operating on a cash or accrual basis? Before you begin looking at the financial statements, you must first comprehend this.


GAAP (Generally Accepted Accounting Principles) requires accrual basis accounting, but only for publicly traded firms. The accrual method of accounting, on the other hand, makes it easier to understand what you're looking at when assessing a business.


The company must follow the matching principle, which requires that revenue and expenditures be recorded when they become due.


When reporting on a cash basis, purchases and expenses are only recorded as cash is received or checks are written to pay bills.


The issue is that many payments aren't due for another month, so you'll end up recording an expense one month later.


In the same vein, what if you gave a big customer 30 days to pay their bill? On the books, cash base accounting can trigger wild swings in profitability. For accrual accounting, you report the transaction or expense as soon as it occurs, and then you record it on the balance sheet as an account receivable or payable.


By comparing sales with the costs incurred to produce them, this form of accounting will give you a much clearer image of the company's profitability.


Statements of Financial Position


Financial statements are perhaps the most important documents you will look at when doing financial due diligence, though they are not the only thing to consider.


You should usually request income statements, balance sheets, and cash flow statements.


You can request at least two years of statements for each of these so that you can make comparisons. Typically, a lender such as the Small Business Administration (SBA) would like to see these as well.


P & L

The profit and loss statement, or P & L, offers a wealth of knowledge about a company's operations.


The P&L, in its simplest form, simply indicates revenue minus expenses to arrive at some income for the time span, which is normally one year.


The numbers will give you a fast snapshot, but it's when you apply ratios that you can really see what's going on in the market.


The most useful ratios are the percentage of income and the percentage change from the previous year.


Simply divide the line item (sales or expense) by the total sales reported on the P&L to get the percent of revenue.


This allows you to easily see the gross margin, net profit margin, and a variety of other key figures.


These figures should be able to be compared to industry expectations and metrics. If you hired an accountant, they should be able to supply you with these documents as well.


These industry guidelines show you where your company should be in order for you to make adjustments whether it is underperforming or over-performing.


Even if the industry benchmarks seem to be valid, you can also relate to previous periods. This will show you patterns about which you may need to inquire further.


Why did this cost jump by 200 percent? Why did sales of this product line plummet by 35%? You wouldn't be able to see these items unless you compared them to a previous time.


Remember to use your common sense as well. If you see a 300 percent rise in an expenditure but it just goes from $1,000 to $3,000 for the year, it's not nearly as significant as a 100 percent increase from $10,000 to $20,000.


Looking at the income statement will also reveal places where you can save money (opportunity) or areas that need immediate attention (problem).


Accounts Payable

The balance sheet is another excellent indicator of a company's financial health. You'll be able to see the company's assets, liabilities, and profits over the course of its life.


You will easily see if a company meets this condition by looking at debt payments on the balance sheet and revenue figures from the P&L.


And if the company has a lot of debt, it's not a big deal because the seller would be responsible for paying it off after the sale.


You'll want to compare the current cycle to the previous one and ask about any significant rises or decreases.


Cash Flow Statement

As the name suggests, this financial statement will include more information about the company's cash flow.


This statement is made up of three parts:


Cash from operating activities – this subtracts all noncash costs such as interest or depreciation from the P&L to demonstrate how much cash operating activities were actually contributing to the business.


Cash flow from funding – this section will show you the cash flow from debt and any dividends paid to shareholders. If this number is negative, the company's liabilities for the year were reduced by a net amount. If it was positive, they most likely borrowed money during that period.


Cash from investing – this segment will show you whether the company purchased (decreased cash) or sold (increased cash) any equipment during the time.


Profits


As you progress through the P&L, one thing you'll want to focus on is sales. Any company's lifeblood is its sales.


Let's look at several places to investigate.


Services and products

Here are some questions to consider when looking at how the business makes money:


What is the source of the sales?

What are the company's different revenue streams?

Are they reliant on a single source of income? (problem) If you were to take over the business, how would you mitigate the risk?

Are there any places where they could expand that their rivals are exploiting? (possibility)

Margins are the distance between two points.

As previously mentioned, you can use percent of income ratios to analyze your financial statements. You do this by looking at the edges.


If you know the industry standards, you can easily see how this business compares and whether there is space for margin improvement by manufacturing efficiencies or a price increase.


This would be easier for a comparison if you could find margins from two or three rivals. If you can find bigger rivals, you'll have a better idea of how big this business can grow.


As you might have noted, a lot of financial due diligence is based on patterns. When you examine individual product sales and margins, try to determine if they are rising, declining, or remaining constant.


In general, it's a positive sign if they're staying the same or increasing. If they are rapidly growing, you can talk with the seller and find out why.


See if there's a way you can expand or scale what they're doing.


If your profits or margins are declining, you should investigate why. In most cases like this, the response might be a deal breaker, but at the very least, you can lower your bid.


Depending about how much knowledge you have, you can use common sense as well.


While sales are down, last year was a record year due to a number of factors. Perhaps revenues have increased after declining for three years in a row.


You'll be looking at a lot of data during due diligence, and when you go through records, you'll get a better picture of the big picture.


Accounts Receivable

Returning to the balance sheet and looking at the company's receivables will reveal more information about the payment arrangements that have been formed with current customers.


Other things to keep in mind:


What is the age of the receivables? If it's been more than 30 days, try to find out what's going on. Is it simply the case that the new operator does not impose payment conditions, or do any big customers insist on longer payment terms?

What is the sales percentage? If this number is big, you will need to raise your working capital budget if you don't expect to be paid for another 30 days and this represents a significant portion of your revenue.

Are there any accounts that are past due? A business could theoretically inflate sales by making fake invoices. Those invoices, of course, will never be charged. Or are they really terrible at keeping track of things? In any case, these may be possible warning flags to be aware of.

Allowing customers to pay in 30 days, as long as payments are made on time, can be a perfect way to promote sales of larger corporate clients.


Expenditures on capital goods

When examining a company's capital assets, it's important to remember not just what they have, but also how old their equipment is.


Have they upgraded their facilities in the last five years, or has it been twenty?


If you're buying a digital business, this shouldn't be a major consideration. However, understanding whether or not you will need to make a substantial cash outlay in the coming years will have an impact on the offer price.


Working Capital is a term used to describe the amount

Working capital is essentially the difference between existing assets and current liabilities. The amount of cash and receivables a corporation has in excess of its current bills due.


In most cases, the purchasing agreement specifies a specific amount to be exchanged at the time of closure.


You should look for patterns here, just as you should with all of these things. Are things getting better, getting worse, or staying the same?


Take a look at your inventory.

When it comes to inventory products, you can try to get a rundown with all of the information for each one. What is the worth of the cash on hand?


Inquire about the last time they performed a physical count. Some businesses convert inventory to cost of goods without actually counting it.


This does not account for fraud, spoilage, or human error.


Expectations (look at past and future from the owner)


If the seller has made previous estimates, request them and compare them to the actual results for the time span.


Ask what happened or why they thought they were off if they weren't near. What assumptions did they use to come up with the forecasts?


When investing your hard-earned money in a business, you should try to learn as much as possible about it before closing the deal.


Financial due diligence is well worth the time investment because it can save you money in the long run or even keep you from making a bad offer.


You should also inquire about potential projections to see where the owner sees the company going.


Some business owners may have quarterly, annual, or even product-specific forecasts.


You should have seen enough data by now to determine whether or not you agree with the forecasts and how much effort it would take to meet them.


Debt Information

Although the debt information won't help you much if you're buying a company because they'll be the seller's liability, you can still learn a lot from looking through them.


Is the debt getting bigger or smaller? Was it because of new expenditures or because they were supplementing working capital if it was increasing?


If it came from the latter, it could be a warning sign, or the seller could simply be inept with money.


In any case, it's not a bad idea to take a look at the current debt and inquire about how it came to be.


Threats from competitors


Finding quality competitor details for the company you're interested in can be difficult, but it's something we strongly advise.


If you can find financial data for two or three rivals, you can quickly decide where this company belongs in the industry.


You will compare profits, margins, earnings, and other financial items as you learn more about the company's rivals.


However, now would be an excellent time to conduct a SWOT review. What are the competitor's advantages and disadvantages?


What can you do to take advantage of them or minimize their impact? Are there any that could put this business in jeopardy?


If you can figure out more about market share, you'll have a better understanding of how big the overall market is.


Systems & Controls


Financial controls and processes are essential for any company looking to expand or scale. You must ensure your workers obey procedures and do not take advantage of you while you recruit and depend on them.


Are there any controls in place, or are there none? This will help you determine how much work you have ahead of you.


It may also indicate how trustworthy the information they're giving you is. Do they have processes in place to ensure that all sales and expenses are accurately and timely recorded?


Do they have mechanisms in place to ensure timely filing of taxes and other government reports?


What accounting software do they employ? (Perhaps not Excel.)


Have they used strong passwords to protect confidential details, or do any of the workers know how much money is in the bank account?


Are their documents safely backed up and stored?


The owner may or may not have several controls, depending on the size of the company. However, you must first define areas of potential risk in order to assess whether or not controls are required.


Multiples of Valuation

All of your financial due diligence up to this point has been done to help you determine whether or not you want to buy the company, and then to make an offer.


All of the following elements should be considered when using a multiple of earnings to arrive at a valuation.


Most likely, you'll be paying 2-7 times the previous year's earnings for a company. The results of your findings, as well as the industry in which you work, will determine where you fall within that spectrum.


Profits

Businesses with a higher cash flow are more likely to sell at a higher price. Investors are willing to pay more for stable cash flow because the company's value will have to plummet dramatically to wipe out their investment.


Operating History A company with a stable income for ten years is likely to be worth more than one that has only been in operation for 18 months.


Comparisons

Businesses may want to get the same multiplier if they are looking at a business in an especially hot industry with well-known exits.


Systems & Controls

How many hours a week does the new owner put in? The higher the multiple, the closer the company is to passive profits.


Friendliness

Other factors, such as brand recognition or intangible assets (industry specialties), can make the owner believe they are worth more. Since this is a subjective figure, you'll have to determine if it's worth it and will have to haggle with the current owner.


Risks and Consequences of Financial Due Diligence Failure


In a nutshell, one big consequence is that you will lose all of your money.


Anyone trying to buy a company hopes to get the best deal and then sell it for the most money, but that isn't always the case.


Financial due diligence is something you can't afford to overlook. Of course, it is impossible to discover anything, but a thorough examination will provide you with a degree of assurance before entering into a transaction.


Some companies may simply be bad at bookkeeping, while others may be concealing information that could influence your purchasing decision or valuation.


You will find out whether the goods or company are in need of a significant overhaul by doing financial due diligence.


You don't want to experience buyer's remorse after making a poor financial decision, particularly if you could have predicted it by asking a few questions ahead of time.


Wrap-up of Financial Due Diligence

As you can see, deal flow is one of the most critical things. When reviewing new businesses for acquisition, this is one place where we take our time.


Don't be hesitant to take your time at this stage of the purchase. Financial due diligence can take anywhere from two to three months. Take your time, read at everything, and ask as many questions as possible.


We advise you to follow suit. If you don't feel comfortable managing this process on your own, get in touch with us right away to see how we can assist.


When you're thinking of closing a deal, it can be exciting, and when you get closer, you can have a tendency to overlook some red flags. Maintain objectivity in this phase.


If you're looking for a step-by-step guide to buying a company, check out our most recent guide.


Main Points to Remember

One of the most critical aspects of an acquisition is financial due diligence.

Take your time if you need to.

It's appropriate to request any of the items mentioned above.

Pose inquiries.

Analyze the offer you're considering, as well as your rivals.

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