Comprehensive due diligence is essential when acquiring a business. Financial due diligence, in particular, can be daunting, especially for inexperienced buyers and sellers. However, with the support of financial and accounting professionals who can evaluate past and future financial statements, spot hidden liabilities, uncover management missteps, and ensure earnings accuracy, this task becomes more manageable. Their expertise provides crucial information that shapes deal terms, purchase prices, and validates key financial information related to your investment decision.

Reviewing the Past and Future

Buyers must examine historical and prospective financial statements to set the right offer price. Reviewing a complete business cycle, covering both peaks and troughs is essential. Relying only on peak-year financials can lead to overpayment based on unusually strong performance. For example, an HVAC company that consistently records peak revenues from May through August every year over a three-to-five-year period offers a reliable pattern. But if a clothing retailer suddenly shows peak revenues during these months after years of winter peaks, this should raise a red flag and prompt further due diligence. Is the May through August bump a one-time anomaly, or could it be considered the new normal?

Typically, examining five years of financial statements helps identify trends. Standard practice includes reviewing the last two calendar or fiscal years and the last twelve months (LTM) of financial results.

Financial due diligence also involves normalizing earnings—removing non-recurring items and correcting misreported figures. This process ensures the purchase price reflects the business's actual earnings, not inflated ones. Items to adjust may include owner expenses, compensation, non-recurring expenses, and related-party transactions.

It's also worth analyzing prospective financial statements based on management's expectations for the future. Likewise, a buyer's offer is likely influenced by how much return the business is expected to generate. Fair market value is a good starting point; however, buyers may be willing to pay more (or less) depending on the situation's dynamics.

Key Areas to Review

• Historical Financial Statements: Examine a complete business cycle, including peaks and troughs, to prevent overpayment. Avoid basing decisions on peak-year performance alone. Example: An HVAC company with consistent summer revenues over several years is reliable, unlike a clothing retailer with a sudden revenue spike outside its historical high season.
• Future Financial Statements: Scrutinize growth assumptions and resource needs. Ensure projections include necessary investments in equipment and staff. Verify who prepared the forecasts—external reports are preferable, but hire your expert for validation.
• Adjusting Financials: Remove non-recurring or non-operational items from earnings. Correct misreported figures to reflect true earnings. Standard adjustments include owner expenses, compensation, non-recurring expenses, and related-party transactions.

Devil's Advocate – Future Projections: What to Watch

When reviewing future financial statements, scrutinize the assumptions behind growth projections. If management forecasts 20% annual growth, consider whether the business has the resources to support this. Additional investments in equipment and staff might be necessary—have these incremental costs been included in the projections?

It's also important to know who prepared these forecasts. Reports by external accountants may follow AICPA standards, but hiring your expert for independent analysis is wise. An external advisor can validate assumptions and provide a realistic outlook.

A buyer should remember that prospective financial statements, projections, proformas, or forecasts are just that – these results have yet to be realized.

Uncovering Hidden Liabilities

Historical balance sheets reveal a company's assets and debts, but some liabilities might not be obvious. Examples include off-balance sheet bonuses, deferred compensation, customer deposits, extended vendor payables, pending lawsuits, and more. These hidden liabilities can directly affect the purchase price.

Additional issues, such as broken equipment or obsolete/slow-moving inventory, can be discovered during financial or operational due diligence. In stock sales, where all shares transfer to the buyer, uncovering these liabilities is crucial to avoid future legal issues. Buyers should also verify the seller's claims to prevent post-closing disputes.

Misrepresentations found later can lead to legal battles. Earnout provisions or escrow accounts can protect buyers if the deal doesn't turn out as expected.

Key Areas to Review

• Off-Balance Sheet Items: Look for liabilities not listed on balance sheets, such as off-balance sheet bonuses, deferred compensation, customer deposits, extended vendor payables, and pending lawsuits. Recognize the impact of these items on the purchase price.
• Operational Due Diligence: Inspect issues like broken equipment or obsolete inventory. In stock sales, uncover all liabilities to avoid future legal problems.
• Verify Seller's Claims: Misrepresentations can lead to legal disputes post-closing. Use earnout provisions or escrow accounts to mitigate risk if the deal doesn't meet expectations.

Mitigating Mistakes

Inexperience in M&A diligence can lead to overpaying, causing future financial issues. Hiring external Transaction Advisory Services or Business Valuation Services professionals is standard, as they provide tailored due diligence and valuation scopes, helping buyers understand the target's assets, earnings, and value. This insight is essential for negotiations and refining your financial models and investment strategy.

Key Areas to Review

• Seek Professional Help: Tailored due diligence and valuation scopes clarify the quality of assets, historical and future earnings, and perceived value.

By focusing on these areas and leveraging professional guidance, you can confidently navigate the complexities of financial due diligence and ensure a sound investment.

Brinker Simpson & Company provides comprehensive financial and accounting services, including M&A due diligence, transaction advisory services, and business valuation. Contact us to learn how we can support your business acquisition needs.