Numbers Don’t Lie: The Crucial Role of Financial Due Diligence
Acquiring a business offers the potential for significant gains, benefiting not only you but your family as well. However, there is also a substantial amount of risk that acquisition entrepreneurs are taking on. If you’re buying a business with a personally guaranteed loan, failure could decimate your financial future. That is why performing sufficient due diligence is so important.
One of the most important aspects of the due diligence process is financial due diligence. In this article, I will provide a comprehensive overview of the essential aspects surrounding financial due diligence within the context of a potential small to medium-sized business (SMB) acquisition.
What financial due diligence is not.
When people first learn about financial due diligence it is very common that they confuse the process for something else.
Here are a few of the common misconceptions people have:
Financial due diligence is not an audit
An audit is a very specific type of engagement that seeks to give an opinion on whether or not financial statements adhere to accepted accounting principles (usually GAAP in the United States).
In contrast, financial due diligence aims to identify and explain trends, while also presenting a normalized view of metrics like earnings before interest, taxes, depreciation, and amortization (EBITDA), seller discretionary earnings (SDE), and net working capital (NWC).
So while a financial due diligence provider may utilize the work of audit financials (if available) during their engagement, the two processes are very different.
Financial due diligence is not a projection/forecast
Financial due diligence is based on historical performance. The analysis of the historical period can be useful when determining the feasibility of a projection or when creating a projection.
That being said, generally an engagement to project future results will be done separately.
Financial due diligence is not a valuation or a recommendation to buy or pass on the deal
A valuation team may use the work from a financial due diligence provider in order to properly value a business. However, a business valuation generally requires a skillset that is different from the skillset of a financial due diligence provider.
Furthermore, the decision to proceed with or decline the deal rests ultimately with you, the buyer. Your financial due diligence provider will present you with relevant facts that can help you to make an informed decision but they generally will not take a hard stance in either direction.
What are the objectives of financial due diligence?
When financial due diligence is complete, the end result is typically a report that can be shared with the buyer, their lender and their investors.
When completed effectively, this report should offer insights into three key areas:
1. Understanding of the business model
It is important to know how the business you are buying is generating revenue and profit. A good financial due diligence report will clearly show how a company has done that historically.
2. Normalized financials
Especially when taking out debt, it is very important to have a normalized picture of the businesses financials.
For most small to mid-sized business acquisitions, the financial metrics that should be of primary concern are: EBITDA, SDE, and NWC.
In order to get a proper picture of these 3 metrics a good provider will utilize a combination of the seller’s business tax returns, bank statements, and internal bookkeeping records to verify that the information that has been presented to you by the seller and their broker is factual.
3. The feasibility of your forecast
While a financial due diligence engagement does not generate projections itself, it does provide you with a series of facts and figures that can help you assess the reasonableness of the projections you have created.
Overview of the financial due diligence process
Every financial due diligence engagement follows a different trajectory. However, generally they will move through 3 overarching stages.
1. Financial Due Diligence Preparation:
Scope the Project
By properly scoping the project you can greatly decrease due diligence costs, save time, and reduce potential dead deal costs.
You do this by carefully outlining the size/complexity of the business, the needs of the lender, your needs as a buyer, and the amount and quality of information that will be available from the seller.
Even if you are already an expert in the industry it is always a good thing to do additional research. Even just spending an hour Googling the target company and skimming a few annual reports from the largest companies in the industry.
This is where you will curate a list of items to request from the seller. Typically, the historical period that is analyzed will be 2-3 years.
At a minimum you’ll want to ask for tax returns, bank statements, and monthly internal accounting records for the historical period.
Format Information/Initial analysis
As you look at companies to purchase in the range of $1-$5MM in enterprise value, what you will find is that the information will be provided in a variety of different formats in most cases.
During this step you’ll want to review every document that has been sent to you and distill all relevant information into a usable format. Oftentimes this comes in the form of an Excel file.
Once the data is in a usable format you can start to analyze it. I recommend starting to analyze the data at the highest level. Then as you notice trends and abnormalities you can drill in and build a list of questions for the seller.
A few examples of analysis that can be performed are:
- Year over year EBITDA bridge
- Tax to book bridge
- Current year outturn
- Seasonality analysis
- Revenue concentration
- Gross margin trends
- Churn Analysis
- Fixed vs variable cost sensitivity
- Employee cost analysis
- Operating expense trends
Q&A with Seller
After doing the high level of analysis it is natural to have built up a list of questions for the seller. I recommend sending a list of those questions to the seller and setting up a meeting for a few days afterwards to go over them.
This allows the seller time to process the questions, saves time during the meeting, and should help to keep them from feeling defensive.
If the seller is not going to be very helpful in answering the questions, ask if they can bring their bookkeeper or accountant into the meeting to provide better answers to the questions.
Once you’ve had your questions answered you can now go back and perform additional analysis.
At this point there should be enough data to start to finalize the quality of earnings report, proof of cash, and net working capital analysis.
Q&A with Seller #2
You may generate an additional list of questions after doing further analysis.
I would advise that you do everything possible to do things to reduce the amount of times you have to go back to the seller with questions in order to reduce deal fatigue. Usually 1-3 meetings will be enough. However, do not let that keep you from asking enough questions to ensure you are comfortable with the business you are buying, each deal is different.
During this step all relevant findings are compiled and compared with other due diligence processes if possible.
Here the findings that will be most important to the users of the financial due diligence report will be summarized into a neat easy to read report.
Review and Finalize
Finally, the report should be reviewed and then shared with the users.
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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.