What Financial Due Diligence Looks For

Buyers often assume that due diligence is a matter of checking whether the accounts are correct. In most cases the accounts are correct. The purpose of the exercise is to establish whether the earnings being presented are the earnings the purchaser will actually receive.

This is the first of four articles on buying and selling a business, and we have started here because it is where most transactions are either resolved or come apart.

Normalised earnings

The reported profit of an owner-operated business is rarely the profit a new owner will experience. The first task is to remove what is attributable to the current owner and add back the costs a new owner will genuinely incur.

The common adjustments include replacing the owner’s remuneration with a market salary for the role, since a working owner drawing $60,000 in a position that requires a $130,000 manager is overstating profit by $70,000. Private items running through the business are removed, covering vehicles, travel, subscriptions and family members on the payroll. Related party rent is adjusted to market. One-off items are stripped out in both directions, whether a legal settlement, a bad debt write-off or an unusually large project. And costs that are absent are added back, because where an owner has deferred maintenance, under-invested in systems or self-insured a risk, the purchaser will meet that cost in the first year.

The result is a normalised EBITDA. In owner-operated businesses the difference between that figure and reported profit is frequently between 20% and 40%, and it can move in either direction.

Working capital

This is the most common source of post-settlement disputes, and it turns on two questions.

The first is how much working capital the business genuinely requires to operate. That is best assessed from the monthly pattern rather than the balance date position, as a business with seasonal stock or uneven debtor collection can appear comfortable at 31 March and be under real pressure in November.

The second is what is being delivered at settlement. Where a vendor collects debtors aggressively and extends creditors in the weeks beforehand, the balance sheet appears sound while the purchaser inherits a working capital shortfall. A normalised working capital target with a settlement adjustment mechanism addresses this, and it should be agreed before signing in a share purchase scenario.

Liabilities that do not appear on the balance sheet

This is where the most significant issues are usually found.

Holiday pay and leave provisions are frequently understated. Inland Revenue arrears, including instalment arrangements, are best confirmed by obtaining a statement of account directly rather than relying on a summary. Warranty and remedial obligations are a particular consideration in construction and manufacturing. Personal guarantees, leases and finance arrangements may bind the business without appearing as debt. Employment disputes in progress or in prospect should be identified. And restraints of trade the vendor has given to a third party can materially affect what is being acquired.

Concentration

The quality of revenue matters more than the quantity.

Where 40% of revenue comes from a single customer, the purchaser is acquiring that relationship, and it may be personal to the vendor. It is worth establishing how long the relationship has been in place, whether it is contracted, and who at the customer makes the decision.

The same analysis applies to suppliers. A sole-source supplier without a written agreement represents a risk, particularly where the terms are informal and favourable because of a long association with the current owner.

Key personnel warrant the same attention, including the vendor. Where the business operates because the owner knows every customer and prices every job, it is not transferable at the price quoted without a substantial handover or a contingent element to the consideration.

The quality of the records

The way the numbers are maintained indicates a good deal about how the business is run.

A reconciled accounting file with sensible tracking categories and a coherent chart of accounts suggests an operator with control of the business. Unreconciled bank accounts, a significant suspense balance and stock counted annually suggest a greater degree of uncertainty.

Where records are poor, the appropriate response is usually to extend the diligence or to structure more of the consideration around delivered performance, rather than simply to reduce the price.

For vendors

The points above form the list a purchaser will work through, and each can be prepared for in advance.

Normalise your own earnings and be able to evidence every adjustment. Tidy the balance sheet, particularly the shareholder current account. Ensure leave provisions are accurate. Document the knowledge that currently sits only with you, including pricing logic, key relationships and processes. And address any concentration issue if you have the time to do so.

Purchasers pay for certainty. Questions that cannot be answered tend to become either a price reduction or a retention.

If you are considering a purchase or a sale, please get in touch.