M&A - Financial Due Diligence

 

The ultimate goal of an M&A transaction is to determine the fair value of a business to be acquired. Financial due diligence is a critical step in investigating financial health of a company with a view to empower buyers to make an informed decision. Financial due diligence entails the investigation of the financial health of the company by meticulously scrutinizing their historical and current financial statements to ascertain their future forecasts and identify any potential risks not readily apparent in the financial statements for the buyer’s perusal, often advising remedial measures to avoid future regulatory or cost implications.

There are, in the normal course of business, two types of M&A transactions:

1) Buy-side – The aim of financial due diligence from a buyer’s perspective is to determine the robustness of the target’s financial health and its prospects as you’d want it to be. It is perhaps the first step to a peaceful M&A transaction journey for the buyer.

 2) Sell-side – The seller should ask themselves what any prospective buyer would expect from the acquisition of their business. If the sell-side performs due diligence on their own company before taking it to market issues can be identified and addressed prior to the buyer getting involved.

3) On very few occasions (in my experience) the buyer chooses to do a financial due diligence on self before going for an acquisition or taking a recently acquired entity into their fold.

Bottom line is the accuracy and robustness of the company’s financial health can make or break a deal!

 

One question that underscores the necessity of financial due diligence – Are there any material misstatements or omissions in the financial statement?

Have revenue and expenses been reported correctly?

Have all accruals been recorded accurately?

What about overheads?

Any out of period incomes or expenses?

Any extraordinary item? Are they really extraordinary or should be considered part of regular operations?

Any misstatement or omission may result in over or under statement of financial performance which in turn might result in inaccurate valuation.

 

Another question being - What are the hidden costs?

Planning for expansion?

Need to update existing IT infrastructure?

Need to purchase new machinery?

Leasing a new office space?

Hiring new staff?

Need new financing for any or all the above activities?

Each decision has a cost component associated to it and hence will impact financial performance.

 

Financial due diligence checklist:

1)     Income statement

2)     Balance sheet

3)     Cash flow statements

4)     Audited financial statements

5)     Customer and vendor contracts

6)     Capital and finance leases

7)     Future projections

8)     Additional information necessitated from any discoveries during your investigation and/or discussion(s) with management

 

Quality of earnings

a.      Check for fluctuations in recorded earnings over the historical period, identify the drivers.

b.      Understand revenue recognition policy of the entity and establish compliance to GAAP.

c.      Understand the customer concentration. Is a significantly high portion of revenue being driven by top 2 or 3 customers or is revenue spread across several customers.

d.      Analyse trends in expenses and identify areas where these seem unusually high and identify the drivers.

e.      Check all transactions have been conducted at fair market value (arm’s length transactions).

f.       Look for exceptional and one-off items.

g.      Check for P&L impact of missing or mis-reported (under or over) accruals.

h.      Check if certain expenses need to be normalized.

i.       Any out of period incomes or expenses and reclass these to correct period.

j.       Check if payroll is recorded correctly – above and below gross margin.

k.      Check for impact of discontinued operations, if any.

l.       Check for expense on new ventures or operations, if any.

m.    Work out a run rate analysis.

n.      Anything else that may stand out.

 

Quality if working capital

a.   Check for volatility in historical period.

b.   Since transactions are on a cash and debt free basis, cash to be moved to net debt.

                                                i.     Check for restricted cash.

c.    Analyse aged AR, AP and inventory.

d.   Understand policy for AR reserve and write-offs.

                                                i.     Any collection issues foreseen for current period?

                                               ii.     Net credit period and any additional discount offered for early payments (might be customer specific)?

e.   Understand inventory valuation, obsolesce, reserves and write-offs. Also, check for any methodology change during the historical period.

f.     Check for accuracy of accruals or missing accruals.

g.   Check other current assets and other current liabilities for non-operational items, tax payables, tax credits or debt like items.

h.   Anything else that may stand out.

 

Net debt (Debt and debt like items)

Net debt is Gross debt less cash – since M&A transactions are conducted on a cash- and debt-free basis. The tricky part is identifying the debt like- and off-balance sheet items.

1)     Debt are balance sheet items like – Long- and short-term loans, notes payable, line of credit, etc.

2)     Debt like item – Items that are not debt in the normal course of business but assume the nature of debt solely because of the M&A transaction in progress. The buyers would like to take over a business that is rid of any liabilities created in the historical and current period. Examples of debt like item can be – Bonus, sales commission due, taxes payable, differential between accrued retirement benefits vs. actuarial valuation report, etc.

3)     Off balance sheet items (also debt like) – Items that are nor recorded on balance sheet but are asset or liabilities for the company. For example, any settlements arising out of ongoing lawsuits, any contingent liabilities, etc.

 

Other Balance sheet items

a.      Addition and disposal of fixed assets. Depreciation and capitalization policy. Capital expenditure incurred to date. Any impairment in the historical period.

b.      Intangibles with definite life and its amortization

c.      Goodwill, trademarks, etc.

d.      Shareholders’ equity – Check for accuracy of Y-o-Y roll forward. Ensure opening and closing balances add up from one period to next.

e.      Any other material information provided in balance sheet.

 

Cashflow statements

a.      What is the health of cashflow from operating activities?

b.      How much cash is being generated post financing and investing activities?

c.      Understand quality of cashflow. Is operating cashflow really growing Y-o-Y or is it something else resulting in a net positive cashflow?

d.      If permissible undertake a sensitivity analysis. What impact can be expected on net cashflow if cashflow from operating activities was to fall by a certain percentage?

 

Other things to consider

a.      Customer and vendor contracts – Read through the master service agreements, statement of work(s) and any addendums. Parties, term, price allocation, termination, and any special provisions. Keep your eyes peeled for any covenant dealing with change in management especially if the customer is contributing significantly to the total revenue from operations or purchases from the vendor is of a significant quantum. In either or both cases, severing ties with the company because of the recent M&A will affect the financial performance of the company.

b.      Finance and capital leases – Go through the capital and fiancé leases and check the company’s accounting policy, ensure the leases are recorded on the financial statements in accordance with GAAP.

 

Once again, the items listed above are only indicative not exhaustive.

 

In summing up, financial due diligence is a thorough investigation of the financial health of a company and any under- or over- statement of financial information will affect the fair value calculation and there it assumes significance in any M&A transaction. Every business is unique in how it operates and therefore comes its own share of experiences making M&A challenging yet exciting!

 

 More to follow soon…….

 

Disclaimer: This is purely an academic pursuit. The views/opinions expressed above are my own and does not reflect the views of my employer.