A Financial Due Diligence Overview [Financial Checklist Included] - Acquira

A Financial Due Diligence Overview [Financial Checklist Included]

What You'll Learn:
  • What financial due diligence is and why you need it
  • What items you should be analyzing before closing a deal
  • Risks and consequences of not doing financial due diligence
  • How long you should spend on financial due diligence

You just closed a deal and bought your first business, sales are humming along for the first six weeks and you’re feeling pretty good.

Suddenly, they tank by 30% for no apparent reason. Upon further inspection, you discover an alarming amount of negative customer reviews from before you purchased the business. You realize that customers have been complaining that the products were becoming outdated and dysfunctional for quite some time, and that if you had noticed these earlier you could have predicted the drop in sales.

Situations like these can be prevented with proper financial due diligence.

Closing a bad deal can’t always be avoided but spending the time looking at the right information will help you feel more comfortable before closing any deal.

What Is Due Diligence?

Due diligence has been around for a long time. It became a common practice amongst securities dealers and brokers with the Securities Act of 1933.

In fact, it was actually included in the act as a defense for securities dealers if they were targeted with unfair prosecution.

However, financial due diligence is just not for security brokers. Anyone looking to make an investment, such as purchasing a business, should perform due diligence with the highest standard of care.

Due diligence is an audit or investigation of the potential business you want to acquire. Besides reviewing financial statements, any interested party should do their best to confirm any stated facts by the seller.

Due diligence is an audit or investigation of the potential business you want to acquire. Besides reviewing financial statements, any interested party should do their best to confirm any stated facts by the seller.

Basically, you want to make sure after you complete the transaction that there are no surprises. While there are sure to be a few, due diligence allows you to minimize the risk going forward.

Financial Due Diligence Checklist

Now that you know what due diligence is and why you need to do it, let’s get into the individual items you should be looking at. Use the following checklist to guide you in this process.

Accounting Principles

Is the company using cash or accrual basis? You will need to understand this before you start looking into the financial statements.

Accrual basis accounting is required by GAAP (Generally Accepted Accounting Principles) but that only applies to publicly traded companies. However, for evaluating a company, the accrual method of accounting makes it easier to understand what you are looking at.

There is a matching principle required where the business records revenue and expenses as they become due.

Someone reporting on a cash basis only records sales or expense as they receive cash or write the checks for the bills.

The problem here is that a lot of bills are not due for 30 days, so you will record an expense one month later.

The same with sales, what if you allowed a large customer 30 days to pay their bill? Cash basis accounting can cause wild swings in profitability on the books. With accrual basis accounting, you would record the sale or expense when it happens and then on the balance sheet you would also record that either as an account receivable or payable.

This method of accounting will give you a much clearer picture of the profitability of the company by matching revenues with the expenses incurred to generate them.

Financial Statements

While they are not the only thing to consider, financial statements are probably the most important documents you will look at when performing financial due diligence.

You will typically want to ask for income statements, balance sheets and statements of cash flow.

For all of these, you will want to ask for at least two years of statements so you can make comparisons. Typically, a lender like SBA will also be wanting to see these from the business.

P & L

The profit and loss, or P & L, provides you with a lot of great information about a business and how they operate.

In its most basic form, the P & L simply shows sales less expenses, to arrive at any profits for the time period which is usually one year.

The numbers by themselves will give you a quick snapshot, but applying ratios is when you really see what is going on with the business.

There are two ratios specifically that are the most helpful; percent of income and percent change from the prior period.

For percent of income, simply divide the line item (sales or expense) by the total sales listed on the P & L.

This lets you quickly see the gross margin, net profit margin and many other important pieces of the puzzle.

You should be able to find industry standards and certain benchmarks for these numbers. If you hired an accountant, they should also be able to provide these to you.

These industry standards tell you where the business should be so you can adjust if it is over or underperforming.

Even if the industry benchmarks check out, you still want to compare to the previous period. This is going to show you trends that you may need to ask questions about.

Why did this expense increase 200%? Why did the sales from this product line drop 35%? Without a comparison to a prior period, you wouldn’t be able to see these things happening.

Don’t forget to use common sense as well. If you see a 300% increase of an expense but it went from $1,000 to $3,000 for the year, that’s not as big of a deal as a 100% increase of something that went from $10,000 to $20,000.

Looking at the income statement may also show you some areas where you can costs (opportunity) or show you areas that really need some attention (problem).

Balance Sheet

The balance sheet provides another great snapshot of the financial health of a business. You get to see what kind of assets the company has, debt and the earnings it has created over the life of the business.

If you remember from our article on purchasing a business using an SBA loan, lenders like to see a debt to income ratio of 1.25 or greater.

Using debt payments you see on the balance sheet and sales numbers from the P & L, you can quickly see if a business meets this requirement.

Even if the company has a lot of debt, it's not a big deal as it will be the responsibility of the seller to take care of it after the sale.

Again you will want to see a comparison from the previous period and inquire about any large increases or decreases.

Is the company accumulating retained earnings over the years or shaving away resources?

Statement of Cash Flow

This financial statement will tell you more about the cash flow of the business as the name implies.

There are three parts to this statement:

Cash from operating activities – this adds back any noncash expenses that may have been recorded on the P & L such as interest or depreciation to show you how much cash operating activities is truly adding to the company.

Cash from financing – this will show you about the cash flow related to debt or and any dividends paid to shareholders. If this number if negative then the company had a net decrease in their liabilities for the year. If it was positive then they probably borrowed money throughout the period.

Cash from investing – this section will show you if the company bought (reduces cash) or sold (increases cash) any equipment throughout the period.

Sales

As you get into the P & L, one area that you will want to dive deep into is sales. Sales are the lifeblood of any business.

Let’s get into some areas to look into.

Products

When looking into how the company makes money, here are some questions you should be asking:

  • Where are the sales coming from?
  • How many different revenue streams does the company have?
  • Are they relying heavily on one source of income? (problem)
  • How could you mitigate that risk if you took over the company?
  • Are there areas they could expand that competitors are taking advantage of? (opportunity)

Margins

As we mentioned earlier, you will want to apply percent of income ratios to the financial statements. In order to do this you look at the margins.

If you know the industry standards, you can quickly see how this company stacks up and if there is room to improve margins by either implementing efficiencies in production or taking a price increase.

Finding margins from 2 or 3 competitors this would be better for a comparison. If you can find larger competitors it may even give you a good idea of how big this company could get.

As you may have noticed a lot of the financial diligence looks at trends. So, as you are looking at the sales from individual products and margins, you should try to identify if they are increasing, decreasing or staying the same.

In general, as long as they are staying the same or increasing this is a good sign. If they are increasing quickly you should speak with the seller and try to figure out why.

See if there is a way you can scale what they are doing or add to it.

If sales or margins are decreasing you will DEFINITELY want to figure out why. Depending on the answer it could be a deal breaker, but at the least, you may want to lower your offer in most situations like this.

Common sense should come into play here as well depending on how much information you have.

Maybe sales are down but last year was a record year that was caused by some factors. Or maybe sales are up but they had declined for three years in a row before that.

With due diligence, you will be looking at a lot of information and it as you go through records you will get a better glimpse of the overall picture.

Receivables

Going back to the balance sheet and diving into the company’s receivables will tell you more about the payment terms established with current customers.

Some items to note:

  • How old are the receivables? If older than 30 days, try to figure out why. Does the current operator just not enforce payment terms or do some large customers demand longer payment terms.
  • What is the percentage of sales? If this is high then you may need to increase your working capital budget if you know you won’t get paid for 30 days and it is a large portion of the sales.
  • Are there delinquent accounts? Technically a company could inflate sales by creating false invoices. Of course, those invoices would never get paid. Or could they just be bad at record keeping? Either way, these could be potential red flags to watch out for.

As long as payments are made on time, allowing customers to pay in 30 days can actually be a great way to facilitate sales with larger corporate clients.

Capital Expenditures

When looking into the fixed assets of a company you will not only want to note what they have but how old their equipment is.

Did they upgrade equipment in the last 5 years or has it been 20?

If you are purchasing a digital business, then this shouldn’t matter too much. But knowing if you will need to make a large cash expenditure in the next few years could certainly affect the offer price.

Working Capital

Working capital is simply current assets minus current liabilities. How much cash and receivables a company has over its current bills that are due.

Usually there is a set amount agreed upon in the purchase agreement to be transferred at the time of closing.

Just like with all of these items you should look for trends here. Are things rising, falling or staying the same.

Inventory

For inventory items, you will want to try and get a breakdown with the details for each item. What is the value on hand?

Ask when the last time they did a physical count. Some companies move inventory to cost of good based on sales without actually counting.

This doesn’t account for things like theft, spoilage or errors.

Projections (look at past and future from the owner)

If the seller has previous projections, ask for them and see how they stacked up against the actual results of the time period.

If they weren’t close, ask what happened or why they think they were off. What assumptions did they make to arrive at the projections?

When you are going to invest your hard earned money into a business you need to try and learn as much as possible about it before you close the deal.

Spending your time with financial due diligence is well worth the cost as it can save you big time down the road or even prevent you from making a bad deal.

You should ask for future projections as well to see where the owner thinks the business is headed.

Some owners may have quarterly, annual or even projections by product.

By now you should have seen enough information to decide whether or not you agree with the projections or how much work it might take to hit them.

Debt Details

The debt details might not mean much for you when you are acquiring a business as they will be the responsibility of the seller but you can still gain valuable insight from looking at it.

Has the debt been increasing or decreasing? If it’s increasing, was it from making additional investments or were they supplementing working capital?

If it was from the latter that could be a red flag or the seller could just be bad at managing money.

Either way, it doesn’t hurt to look at the current debt and ask about how it got there.

Competitors

Finding quality information on competitors for the business you are looking at might not be easy to find but is something we highly recommend.

If you can find financial information for 2-3 competitors then you can instantly determine where this business fits into the market.

As you gain information on the companies competitors, you can see how sales, margins, earnings, and other financial items compare.

However, it would also be a great time to perform a SWOT analysis. What are the competitor's strengths and weaknesses?

What can you do to take advantage or mitigate those? Are there any that pose a threat to this company?

If you can find out any information about market share this could give you an idea of how big the whole market is.

Controls & Systems

Financial controls and systems are vital to any business that wishes to grow or scale. As you hire and rely on employees, you will need to make sure they follow procedure and cannot take advantage of you.

Do they have any controls in place or do they have none? This will give you an idea of how much work you have in front of you.

It might also tell you how reliable the information is they are showing you. Do they have systems to make sure all sales and expense items are recorded properly and in a timely manner?

Do they have systems in place that ensure taxes and other government reports are filed in a timely fashion?

What kind of accounting software do they use? (Hopefully not Excel)

Have they secured access to sensitive information with strong passwords or do all of the employees know how much is in the bank account?

Are their records backed up and stored securely?

Depending on the size of the business, the owner may or may not have many controls. However, you will need to identify areas of potential risk to determine where controls might be necessary.

Valuation Multiples

All of the financial due diligence up to this point is to help you decide if you even want to purchase the business but then to come with an offer.

When using a multiple of earnings to come up with valuation, all of the following items should factor into your decision.

Most likely you will be purchasing a business for 2-7 times the earnings of the last 12 months. Where you are in that range will depend on the results of your findings and often times the industry of the business.

Earnings

Businesses with higher cash flow tend to sell for higher multiples. Investors are fine with paying more for healthy cash flow since the business would have to drop significantly to destroy their investment.

Operating History

If the company has a steady income for 10 years it is probably worth more than a company that is only 18 months.

Comparables

If you are looking at a business in a particularly hot industry with well-known exits, businesses may wish to get the same multiplier.

Controls & Systems

How much time is the current owner putting in each week? The closer the business is to passive income the higher multiple it will sell for.

Goodwill

There may be other factors such as brand popularity or other intangible assets (industry specialties) where the owner just feels like they are worth more. This is a subjective number so you will have to decide if it is worth it and probably go back and forth with the current owner a bit.

Risks and Consequences Of Not Doing Financial Due Diligence

In a sentence, one major consequence is losing all of your money.

Anyone looking to purchase a business wants to buy it at the lowest possible price and sell it for the highest, but that’s not always reality.

You cannot afford to skip out on financial due diligence. Of course, it is impossible to uncover everything, however, you can certainly gain a level of confidence going into a deal after a thorough look.

Some businesses might just be bad at bookkeeping and others may be deliberately hiding something that would affect your buying decision or valuation.

The products or business could be in need of a major overhaul, and you can discover this through your financial due diligence.

You don’t want to have buyers remorse after making a bad financial investment, especially if you could have seen it coming by asking a few questions.

Financial Due Diligence Wrap Up

As you can see this is one of the most important aspects of deal flow. It is one area that we do not rush when are evaluating new businesses for purchase.

Don't be afraid to take some time during this part of the acquisition. It is not uncommon for financial due diligence to take 2-3 months. Be thorough, look at everything and ask as many questions as you can. 

We recommend you do the same. If you don’t feel comfortable overseeing this process by yourself, contact us today to see how we can help.

It can be exciting times when you are thinking about closing a deal and as you get closer, you may have a tendency to be OK with some red flags that come up. Be sure to stay objective during this process.

If you are looking for a full roadmap to buying a business, check out our latest guide for help.

Main Takeaways

  • Financial due diligence is one of the most important aspects of an acquisition
  • Don't be afraid to take your time
  • It's normal to ask for all the items listed above
  • Ask questions
  • Analyze the deal you're looking at, but also do some analysis on competitors

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