Financial Due Diligence: A Critical Step When Buying A Business
Updated: Jul 31, 2020
When contemplating a major purchase, we typically go through a series of checks and balances to ensure we’re getting a great quality product at a reasonable price. This involves countless hours researching the product or service, reading through multiple customer reviews, and consulting with our family and friends. At the end of the day, all of this hard work and effort pays off because you’re more confident that you paid a reasonable price for a superior, high-quality product. Why should this be any different when buying a business? Accounting and finance professionals are often engaged to conduct financial due diligence to assist in analyzing the target company and providing them with the information they require to make a well-informed decision. The total scope and benefits of this process are not always known at the outset of the engagement which is why we decided to shed some light on this matter in today’s blog post. Performing a thorough check of the business, prior to purchasing, can help identify fundamental issues that should be addressed or can result in an adjustment to the overall purchase price. Please explore our resources below and let us know your thoughts.
Financial Due Diligence
The financial due diligence process can be described as a review of the financial records of the target company. The term is quite broad as financial due diligence can refer to many aspects including a review of the company’s financial records, tax returns for compliance purposes, quality of earnings, confirmation of assets and asset valuation – just to name a few. Many times, it is difficult and overwhelming when reaching out to a professional to determine what needs to be done as you are trying to balance the costs of the due diligence process along with trying to effectively manage your risk at the same time. As a result, we will go through some of the key considerations that should be made when determining the extent, nature and scope of work that might be best suited for your situation.
Determining the amount of work required is a matter of professional judgement and the level of risk you are willing to accept as a buyer. If this is your first business purchase or a large transaction, you may have a lower risk threshold and want to seek the expertise of a professional to obtain some comfort surrounding the financial health of the business. However, if you have experience running a business and it is a small transaction, you may be comfortable assuming more risk and are not too concerned doing a deep dive. The nature and extent of work can also vary depending on the quality of information available. If you have unaudited financial statements and records which are prepared internally without the help of an accountant, you may want to have a more detailed review by your accounting professionals. However, having audited financial statements can result in a greater reliance on the financial information. This is due to the fact that the financial statements have been subject to audit verification. A professional has attested that the financial statements are free from material misstatement and are in accordance with the applicable accounting and auditing standards. Having an audit or review done on the financial statements does not eliminate the need for a financial due diligence review since these engagements are completely different in scope and both achieve different objectives. An audit provides comfort that the underlying financial information being used is free from material misstatement and is likely to be more reliable and accurate. However, in a due diligence engagement, every dollar change could have a significant impact on the overall transaction.
A common multiple in arriving to the purchase price of a business is Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). For example: Sellers may set the purchase price of the business at 3 times their annual EBITDA. If the companies EBITDA were $400,000, the selling price would be $1,200,000. When the purchase price is determined on a specific multiple, it may be prudent to have a thorough due diligence process conducted on aspects of the calculation since the purchase price is impacted for every dollar increase/decrease in EBITDA. As a purchaser, you could overpay if there were errors in arriving at this amount, especially when statements have not been subject to audit or review. Using the example above, If the professional finds $20,000 worth of adjustments which reduce EBITDA, as a purchaser, you could be entitled to a reduction in the purchase price by $60,000. As a seller, you could potentially have listed your business at a lower selling price and could lose out on additional value. As a you can see, the cost of financial due diligence can quickly be offset by any adjustments that are found prior to listing a business or prior to purchasing one.
With privately run businesses, it is not usual to see “normalization adjustments”. A normalization adjustment helps eliminate non-recurring or one-time expenses or revenue in the financial statements to reflect the usual transactions of the company. It can also be done to eliminate the impacts of the owner’s personal/discretionary expenses which have gone through the financial statements of the business. For example: Revenue in the current year might have gone up 30% but that was due to a one-time large order and does not reflect sustainable recurring revenue. In addition to this, normalization adjustments might have to be made in privately owned businesses where the owner takes an unusually high or low salary for the work performed to bring it to a market rate for which an unrelated party would expect to be paid for the same or similar type of work.
Lastly, you want to review the compliance history of the company, especially when it comes to a share sale. If they have been subject to compliance audits, filed erroneous remittances or have taken aggressive tax positions in the past, you may be liable for any audits or findings in the future. Payroll taxes, sales taxes or income taxes should be reviewed for compliance to protect yourself from future obligations down the road. Having someone review this prior to purchase can provide you with the information to structure the purchase agreement accordingly to avoid being responsible for additional liabilities for a period in which you did not own the company. Buying or selling a business is a significant milestone. Understanding the business prior to the purchase can help ensure you are getting a quality business for a fair price. There are many areas we look at when performing a financial due diligence engagement to provide our clients with the information necessary to make an informed decision. Although you may not have a large budget to spend on an elaborate and thorough due diligence process, we strongly encourage you to discuss with a professional to help guide you and focus your resource on key areas to ensure you are not left with a poor investment and can safeguard yourself to a certain degree. If you require any assistance or professional guidance navigating through the above, please feel free to contact us for a free consultation. At Pratik Mehta Professional Corporation, we are always here to help you grow your business and advise you on every step of your journey.
Disclaimer: The above post and information are just a few consideration areas when involved in the financial due diligence process. The list is not exhaustive and highlights some considerations to be made when contemplating the purchase of a business. The information provided above can change based on your specific situation and a professional should be consulted to understand the full scope and consequences to you. PM Professional Corporation is not to be held liable for the use of this information without consulting a professional.