The due diligence phase of an acquisition is typically performed after a letter of intent is executed between a potential Buyer and the Target (Seller). This process often involves a third party performing a quality of earnings analysis or agreed-upon diligence procedures over the Target’s historical financial statements. The due diligence phase is critical for a Buyer to better understand the Target’s business operations and the overall quality of the financial information, often leading to adjustments to the contemplated purchase price. Below are five key items to review during the financial due diligence process.

1. Historical Financial Statements

An interested Buyer should not rely on one year of financial statements when considering a potential acquisition. They should review at least 2-3 years of historical financial statements as well as the results from the most recent trailing twelve-month period. Reviewing multiple years allows a Buyer to analyze if the company is in growth mode, stagnant, declining, or other. This can also shed light on whether the Target’s projected financial statements appear reasonable.

2. Accounting Policies

It is important to understand whether a Target’s financial statements are on a cash or accrual basis, as well as its standard accounting policies. For example, improper revenue recognition is a common finding during the diligence process. If a company receives customer payments prior to providing a good or service, the cash received should be reflected as deferred revenue (liability) on the balance sheet until it is earned.

If deferred revenue is not properly recorded, revenues will be overstated, and liabilities will be understated, resulting in an inflated purchase price. The Buyer should determine the amount of deferred revenue that exists at the transaction date and either ensure an equal amount of cash stays with the company on a go-forward basis or reduce the purchase price accordingly.

3. Balance Sheet

If the Target’s financial statements are not audited, the Buyer should strongly consider tying out, at a minimum, the last two years of the major balance sheet accounts. If a Buyer is confident that the balance sheets are accurate, then the income statement inherently should reflect the appropriate amount of revenues and expenses incurred during that timeframe.

Additionally, the Buyer should review for potential unrecorded prepaid assets such as rent, vendor prepayments, insurance, and unrecorded liabilities such as payroll, vacation, commissions, royalties, deferred revenues, self-insurance, and warranties. Identifying these items is important as they will impact the income statement and working capital of the Target.

4. Income Statement

The purchase price of a transaction is often based on a multiple of EBITDA or some other metric. Understanding the fluctuations within the historical income statements helps the Buyer not only better understand the ins and outs of the business but also determine if the purchase price should be based on the trailing twelve-month period or an average of historical years.

Reviewing for fluctuations within the income statement also helps identify any non-recurring, non-operating, personal, and out-of-the-ordinary income or expenses that should be added back to EBITDA. Additionally, pro forma adjustments may be identified related to expenses or revenues that are expected to change post-transaction. Common pro forma adjustments include adjusting salaries, benefits, and rent to agreed-upon amounts post-transaction.

Customer and vendor concentrations are also important to identify. There is more risk involved with a Target reliant upon a small number of customers and vendors to operate.

5. Working Capital

Most transactions include an agreed-upon net working capital (NWC) target that the Buyer will acquire as a part of the transaction. Any deviation from the agreed-upon NWC at the transaction date results in an adjustment to the purchase price. Although the standard components of NWC are accounts receivable plus inventory, less accounts payable and accrued expenses, other assets and liabilities may also need to be considered, such as deferred revenue and customer deposits.

There are many additional factors to consider when setting a NWC target, such as the industry and expected future growth of the company. If a company is projecting significant growth over the next 6-12 months, utilizing historical NWC may not be a good indication of the NWC needed for future operations. Understanding the Target’s NWC requirements is crucial to ensure an appropriate NWC target is set.

Work With Lutz M&A

The due diligence process is not one-size-fits-all and should be tailored to each individual transaction. Lutz M&A assists with a wide range of buy-side and sell-side due diligence, with the procedures specifically tailored to the pertinent details of each transaction. Contact us for more information on how Lutz can help with your next acquisition or prepare your business for a future sale. You can also visit our Lutz M&A blog to learn more on related topics.