Due Diligence: An Overview

Due Diligence (“DD”) is a critical step in the process of purchasing a business. It typically involves procedures to assess the Quality of Earnings (“QoE”), or can be extended further to include analysis of net assets, tax compliance, and business processes. The findings presented in either a QoE or DD report can play a decisive role in whether a purchaser proceeds with purchasing a business or not.

Quality of Earnings
A QoE report specifically refers to a detailed review and analysis of the financial records of a business, with a particular focus on the income statement. A QoE Report can highlight critical business factors, described below:

• EBITDA: Assessment of the EBITDA of a business presented by a seller may reveal adjustments that are inaccurate or based on faulty methodology, potentially leading to an EBITDA calculation that is unsustainable or unreliable. If these items are not identified, they may inflate the purchase price.
• Working Capital Analysis: Detailed review of the liquidity of a business can identify issues in meeting short-term obligations that could impact operations, especially post-closing of a transaction. The findings may enable the purchaser to renegotiate terms or alternatively, request an adjustment to the purchase price, since certain issues with respect to working capital (e.g. collections of accounts receivable) can only be known post-closing.
• Revenue: Analysis of contribution margin and/or gross margin, as well as customer concentration risk and seasonality factors may reveal situations where a business is overly reliant on a particular product, service line or a large customer, or where sales have been inflated. This could increase the potential risk associated with the business, and reduce the purchase price.
• Cash Reconciliation: A procedure that is used to support the collection of revenue reported on the financial statements, potentially identifying situations where the business is engaging in earnings management or other methods of misstating revenue and profit.
• Trend Analysis: A review of changes in material income statement and balance sheet line items to assess if the business is subject to risks that have not been identified by the seller (e.g. issues with collections, overdue payables, declining sales or margins, etc.).
• Related Party Transactions: Review of transactions with non-arm’s length parties, which may include transfers of funds, sales, or purchases, which may or may not recur post-closing, or may not have occurred at market rates pre-closing. This may distort the reported and forecasted results, and ultimately, the purchase price.
• Underlying Operations and Processes: Assessment of accounting policies and operational processes may reveal issues or deficiencies that could result in financial or regulatory compliance risks that will require mitigation before a transaction can occur.

Due Diligence – Tax and Compliance Issues Uncovered
Due Diligence will typically involve a Quality of Earnings analysis, with additional focus on the balance sheet, tax compliance, and/or the processes of a business. In some cases, further review of special regulatory or legal compliance may also be required, depending on the nature of the business. These procedures can identify potential issues, including, but not limited to those noted below:

• Review of Tax Filings: Review of previous tax filings to confirm compliance and consistency with financial statements and other records that may have been shared.
• Review of Tax Balances: Review of tax accounts (e.g. income, sales, payroll, etc.) to confirm any tax assets or liabilities that may exist at the closing date, or uncover potential tax exposure, such as inaccurate filings, or a history of non-compliance.
• Compliance/Regulatory Review: Special procedures, if requested and in coordination with other professionals, may reveal risks of unknown liabilities and other potential legal exposure (e.g. contamination of premises, non-compliance with financial regulations, etc.).

Ultimately, the level of due diligence and related procedures can vary based on the size and potential risk of the transaction being considered.

GG Observations
Our team of corporate finance and tax professionals have the requisite knowledge and experience to assist you throughout the due diligence process for a variety of industries and business sizes. Obtaining the services of an experienced due diligence advisor can help you understand the underlying financial and operational risk factors, allowing you to make an informed decision regarding the purchase or sale of a business.