By Robert Belcher, CPA
Recently we performed financial due diligence on a manufacturing company in Fort Lauderdale, Florida. The purchase price for this transaction was based upon a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). Our client, the buyer, was primarily concerned that the amounts reported as net income, as provided by the seller, were a true representation of the profitability of the business.
Our due diligence procedures included assessing the costing method the seller had used to value their inventory. As we performed testing and recalculated the inventory valuations, it became apparent that the inventory amounts reported by the seller were overstated. Because the seller had not updated the costing methodology in several years, the amount of labor and overhead being applied to the finished goods inventory, as well as work in progress inventory, was significantly higher than the costs being incurred by the company to produce their products.
Our procedures also revealed a significant amount of obsolete inventory on hand that had not been written down to fair market value. Over the last couple of years, the company had reevaluated its product lines and discontinued several of its products but had continued to value these inventory items at full cost. Other due diligence procedures performed on accounts receivable resulted in an increase to the reserve for doubtful accounts for accounts which should have been written off.
As a result of the due diligence procedures performed, we recalculated the inventory and accounts receivable amounts, which resulted in a significant reduction to net income and EBITDA for the trailing twelve months. The total effect of these adjustments was to decrease EBITDA by $2,000,000 from the amounts previously reported by the seller. The buyer was able to take this revised EBITDA information into their price negotiations with the seller. While the transaction went forward, the purchase price paid by the buyer was approximately $2,000,000 lower than what the buyer had originally offered in the letter of intent.
This experience points to the need for performing proper due diligence when buyers are involved in a merger or acquisition. They must identify the risks and opportunities associated with the business under consideration. Unexpected surprises in the quality of earnings, undisclosed liabilities or overvalued assets can lead to a failed transaction. Conducting effective due diligence may identify issues which feed into price negotiations and reduce the risk of paying too much. Effective due diligence can also help identify risks and areas where legal protection should be sought.
Naturally, the primary reason to acquire a company is for an investment opportunity. The buyer must determine if the investment, combined with the expertise and resources of the new owner, will result in an accretive investment. The objective of financial due diligence is primarily to help the buyer identify findings that may impact the purchase price and purchase decisions. The buyer may also use these findings to assess future prospects of the target and how they can be realized, look for vulnerabilities with the target and identify opportunities. Most financial due diligence is done on site at the offices of the target which can also be a good source of other non-financial business information about the target company.
No two businesses are alike, and no single due diligence strategy will satisfy every buyer. Often there will be special areas of concern depending on the deal. A buyer must decide early in the process what areas are likely to be the most important. Each due diligence engagement should be customized to meet the needs of the buyer.
Some typical due diligence procedures would be related to:
- Assessing financial trends
- Judging accounting policies and procedures
- Evaluating working capital trends
- Probing revenue recognition policies and procedures
- Gauging reserves and allowances
- Determining capital expenditure needs
- Weighing net realizable value for assets
- Understanding unusual or nonrecurring transactions
- Recalculating EBITDA amounts
- Identifying unrecorded liabilities
One of the benefits of a properly executed due diligence program is that it can help highlight areas of uncertainty where some provisions need to be incorporated into the purchase agreement, such as warranties, indemnities or other forms of protection. The buyer should not regard financial due diligence and legal protection as substitutes.
Additionally, a well executed due diligence plan gives the buyer an opportunity to identify issues big enough to break the deal or spotlight smaller issues which could possibly reduce the purchase price. Due diligence may identify assets that have been over or under valued, expose unrecorded liabilities which end up being left with the seller, or the exercise may identify tax efficiencies that are best achieved by leaving debt in the business or by acquiring stock instead of assets.
A due diligence plan seeks to explain results. It begins with information provided by the target company and is supported by interviewing key members of the management team. It takes reported results and arrives at underlying profitability after isolating unusual or nonrecurring revenues or expenses. Underlying profitability is the profit which the target company is capable of earning.
Some typical unusual or nonrecurring revenues or expenses are:
- Owner expenses
- Affiliated company or other management charges or expenses
- One time expenditures
- Sale of assets
- Change in or inappropriate accounting policies, practices or procedures
Decosimo professionals have performed many due diligence engagements and have assisted clients in arriving at such a plan, as well as determining the best course of action. If you have questions regarding a transaction or due diligence matter, please call us in confidence at 800-782-8382.