How to conduct buy-side financial due diligence

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Financial due diligence can make or break an M&A deal. This guide covers the three pillars of the process – quality of earnings analysis, net working capital levels, and debt/debt-like items identification.

How to conduct buy-side financial due diligence: The three pillars

Financial due diligence in M&A is the process of ensuring the price of a business is in line with its operating performance “under the hood.” The three pillars of this process are: the quality of earnings analysis, determination of net working capital levels, and identification of debt and debt-like items.

Recent history provides cautionary tales highlighting the make-or-break importance of financial due diligence. The HP-Autonomy deal in 2012 led to protracted legal battles due to inaccuracies in the former’s income reports, balance sheets, and cash flow statements. And Paulson & Co’s Sino-Forest investment hit the headlines a year earlier in 2011, after a class action lawsuit alleged that the hedge fund had not conducted adequate due diligence into the forestry company’s shaky auditing and finances.

In this guide, Hilton Smythe takes you through how to avoid a due diligence disaster with a walkthrough of best practices – from quality of earnings analysis through to correctly identifying debt and debt-like items.

“What should I be looking at?”

A quality of earnings (QofE) analysis is important, because it measures the portion of profits derived from genuine business improvements—increased sales or reduced costs—rather than accounting tricks. These manipulations might include inflating inventory values, altering depreciation, or accrued revenue.

Validating adjusted EBITDA, which is usually used as a proxy for operating cash flow in mid-market M&A, is a key part of the process.

You and your advisory team will want to look at:

  • Non-recurring (or non-operational) items of income and expense
  • Normalising (pro forma) adjustments
  • Accounting adjustments
How to conduct buy-side financial due diligence

A quality of earnings analysis might also look at free cash flow (FCF= EBITDA ± ∆NWC – C – t, where NWC is reported net working capital, C is normal replacement capital expenditures, and t is the taxes paid).

FCF provides insights into the actual cash available for debt repayment, dividends, or reinvestment, because it accounts for tax payments, interest payments, working capital changes, and capital expenditures. It can therefore provide a more comprehensive view of a company’s true cash-generating ability.

Prospective buyers might also want to dig into some other financial and commercial nitty-gritty, such as possible CapEx needs, profit margins on products/services, employee turnover and compensation, inventory, monthly and yearly trends, customer concentration and more.

M&A transactions are usually completed with an expectation that a normal level of net working capital (NWC) be delivered at close, allowing the business to continue operating without the need for a cash injection. A crucial aspect of financial due diligence is therefore calculating the average working capital target, often referred to as the working capital peg.

How to conduct buy-side financial due diligence

This target protects the buyer by reducing the purchase price if the amount of working capital is less at closing than the parties agreed to. The NWC is a common cause for post-closing litigation, so getting this right is crucial.

The average working capital peg varies significantly depending on the industry, business model, and specific company characteristics, and is usually calculated using one of two methods:

  • As a historical average
  • As a percentage of revenue.

It will typically range from 20% to 40% of annual revenue for many businesses, but will ultimately depend on factors such as industry norms, seasonality of the business, payment terms with customers and suppliers, and growth rate of the company.

Important elements to pay attention to include:

  • Accounts receivable
  • The quality/quantity of inventory
  • Accruals

For receivables, you should only include those accounts collectible in a normal business cycle, excluding those that are overdue or disputed and those with extended terms. You should also look at the quality and quantity of inventory, because old or obsolete inventory, or insufficient levels of inventory, would require you to commit additional capital.

Most deals will be conducted on a cash-free, debt-free (CFDF) basis, meaning that the seller retains their cash and settles all debt and debt-like items at closing. This is because business valuations are usually driven by an EBITDA methodology, which excludes the impact of debt and non-operating assets.

Straightforward enough? The first category, interest-bearing debt, is easy enough to identify, including things such as lines of credit, mortgages, capitalised equipment leases and shareholder notes. However, determining which items qualify as “debt-like” is more awkward.

Debt-like items operate like debt but are typically non-interest bearing and can relate to operational and non-operational liabilities. They might include:

  • Credit card liabilities
  • Payables with extended payment terms
  • Legal payments due
  • Accrued vacation, bonuses and severance
  • Accrued interest
  • Deferred rent

Deferred revenue demands particular attention. While the seller may retain the cash, the buyer would inherit future obligations to deliver services or products. Evaluating the status of deferred revenue therefore requires considering the cost to the buyer of performing the related services after close. In SaaS deals, where the deferred revenue is a result of a recurring subscription and the cost-to-service is minimal, the seller might not be required to fund this liability.

Ultimately, classifying cash, debt, and debt-like items is a delicate task, as no universal standard defines appropriate cash-free debt-free (CFDF) adjustments, and Letters of Intent (LOIs) often overlook these subtleties. This process is crucial for both parties, as a significant portion of the purchase price may hinge on the final definitions of these categories.

“What other nitty gritty should I be paying attention to?”

You should check that your target is following the 8 principles of UK GAAP. These include the ‘revenue recognition principle’, according to which all revenue should be recognised in the period that they were earned, and not when the cash was received, and the ‘full disclosure principle’, according to which a business should disclose all relevant and necessary information to give full transparency to stakeholders and investors. You may want to check that the company has an independent accounting firm to prepare and audit its financials.

You’ll want to look at the business’ ongoing financial commitments, including leases, debt repayments, and salary costs. Ask yourself: what is the business’s flexibility in adjusting overhead costs in case of a slump in performance? And are creditors being paid on time and is every liability accounted for?

Look at the value of the assets given on the balance sheet: are these reasonable? The valuation methods used to determine the reported asset values should be appropriate for the asset type. For example, cash and cash equivalents are typically reported at face value, while property, plant, and equipment may be valued at historical cost less accumulated depreciation.

You’ll want to identify and understand any off-balance sheet arrangements, such as operating leases or contingent liabilities, that could have a significant impact on the company’s financial position. Contingent liabilities might include product warranties, legal claims, or HMRC disputes.

“How long should financial due diligence take?”

Or how long is a piece of string? The truth is that the complexity of an acquisition target’s business and records significantly influences both the length and cost of financial due diligence.

Small business acquisitions typically require 45 to 60 days for the whole due diligence process. More complex deals, such as those involving private equity groups or strategic buyers of comparable-sized businesses, often extend from 60 to 180 days.

While the due diligence process “unofficially” begins the moment the buyer sets eyes on a potential target, the official due diligence process begins when two key documents are signed: the letter of intent to purchase the company and the confidentiality agreement.

Confident financial due diligence is an important part of M&A success

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