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Top 10 things to look out for during financial due diligence by Tim Whitehouse

When looking at a potential acquisition target there are a number of factors that should be considered to ensure that what is being presented in the accounts provides a true reflection of the business. Most of these tips also apply when performing due diligence on a key business partner.
Tim Whitehouse, founder of cloud accountancy firm and financial due diligence specialists Caprica Online Accountants, offers his top tips on what to look out for during financial due diligence.
1. Cash conversion Ultimately the true value of a business lies in the future cash flows. If a company is presenting accounts showing a significant variation between the level of EBITDA (Earnings before interest tax, depreciation and amortization) and operating cash flow before capital expenditure then further investigation is required into just where that cash is going.
2. Working capital profile If the total value of working capital (calculated as trade debtors + stock – trade creditors) is positive then this is likely to mean that additional growth will require more cash to fund working capital. Something often overlooked in a forecast. Conversely, if a business has a negative working capital profile growth will normally result in cash being released from working capital. To get your head around this think about a retailer that buys stock on 60 day credit terms but sells that stock for cash within 10 days. They get to hold on to the cash for another 50 days.
3. Stretching working capital A particularly scheming shareholder selling a business might aim to stretch working capital prior to acquisition completion. Since most acquisitions work on a cash free / debt free basis this equates to a higher amount of consideration paid by the acquirer. This can be done by chasing clients to pay up as fast as possible, selling down any stock and not paying suppliers. The purchaser will of course be required to put the same amount of cash back into the business to return everything back to normal. A working capital adjustment mechanism based on an average historical level of working capital is a typical solution to this problem during an acquisition.
4. Changes in accounting policy Changes in accounting policy tend to artificially impact the level of profits a company generates. For example, when a customer pays annually in advance for a service a company may be able to recognize the sale on receipt of the cash or instead recognize one twelfth of the sale each month for the duration of the contract. Switching from the latter to the former in the year prior to sale will make it appear that there has been strong sales (and profit) growth when in reality there may have been no change to the underlying business.
5. Client loss rate Ideally a business will have a loyal client base. Inevitably a certain level of clients will be lost each year, though hopefully more than replaced by new clients. If you can obtain the information it’s very useful to look at the monthly rate of customer losses over an extended period (perhaps three years). An increasing rate or a rate higher than similar competitors may indicate an underlying problem.
6. Adjusting for one off costs and sales Every so often all businesses will incur big one-off costs. In the last few years a large amount of businesses have been forced to downsize, resulting in costly redundancies. If there is a high likelihood these costs won’t occur each year then you should adjust these costs out of the profits when valuing the business. The same applies to any non-recurring sales that may have occurred. Perhaps a business is doing great supplying services for the preparation for the London Olympics, a source of revenue that will abruptly halt at some point.
7. Depreciation vs Capital Expenditure Depreciation aims to spread the cost of an asset over its useful life. An established business will be finding that as the life of an asset comes to an end it requires replacement. The cost of this replacement can be found in the capital expenditure line of a cash flow statement. If capital expenditure is significantly less than the depreciation expense it suggests the maintenance of assets is being neglected and may require big future payments.
8. Trends in gross and operating margin If the information is available it can be illuminating to look at the trends of gross margin and operating margin over time. Increasing rates are indicative of a growing business that is able to successfully leverage its cost base. Declining margins are a big cause for concern. It may be being caused by competitive pricing pressures or a failure by management to keep a hold on costs.
9. Off balance sheet liabilities Too often accounts don’t include all liabilities, either because of particular accounting policies or because of a lack of care. A classic example during an acquisition occurs when an acquirer is looking to leave the offices of the acquisition target to integrate the team into their own offices. Even if the contract allows the company to leave on short notice it will usually require that the premises be returned to their original condition. If the company has made big changes there can be big costs involved with putting everything back how it was.
10. Customer concentration Some businesses are highly dependent upon a single customer (or supplier). If this is the case you should carefully consider the likelihood of losing that customer and the business impact. Don’t’ forget that sometimes what appears to be the strongest of businesses can unexpectedly fail.
You can find more fromTim on Twitter https://twitter.com/#!/TimCaprica or visit his website http://www.capricaonline.co.uk/
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