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Financial Due Diligence: How to Avoid Overpaying for a Business

Along with legal due diligence, financial due diligence is a critical step undertaken by a prospective acquirer of a business.

Financial due diligence consists of a detailed review and analysis of the financial records of a business, including financial statements, tax returns and other information, depending on the level of review requested by the users.This analysis is particularly important as any potential inaccuracies or inappropriate adjustments to normalized earnings or net assets may result in an inflated purchase price. Transaction multiples based on historical adjusted EBITDA figures are commonly used to calculate the price of a business. Therefore, if a business is being acquired at 5x EBITDA, every dollar of inflated EBITDA leads the acquirer to pay an extra five dollars.

Buy-Side versus Sell-Side Due Diligence

Buy-side due diligence typically involves assessments of the sustainability of the revenues, earnings and cash flows of the target business, as well as verification of key assets and liabilities balances that may impact the earnings and working capital requirements of the target. A detailed due diligence report highlights potential issues and can be used by the acquirer to negotiate a better purchase price and terms to be paid for the target business.

On the sell-side, owners preparing to list their business for sale can require a due diligence report to uncover potential issues and areas of concern, so that they can be addressed before they are discovered by a potential buyer. Unaddressed issues on the sell-side have the potential to reduce the negotiating power for the seller, reducing the ultimate sale price and in some instances, leading a qualified buyer to abandon the transaction altogether.

Quality of Earnings (QoE) versus Due Diligence (DD) Reports

While the terms are commonly used interchangeably, a Quality of Earnings report specifically refers to a detailed review and analysis of the financial records, including historical income statements and balance sheets of a business.

These procedures commonly include, but are not limited to, the following:

  • Analysis of the seller’s EBITDA and/or discretionary adjustments to assess both reasonability and sustainability;
  • Working Capital Analysis to determine the day-to-day cash flow requirements of the business;
  • Product and service revenue and margin analysis, including customer concentration risk and seasonality factors;
  • Analysis of major income statement and balance sheet items to identify potential trends and risk factors;
  • Analysis of related party transactions;
  • Details of key operational information including any unusual accounting policies and processes; and
  • If requested, a detailed cash reconciliation to verify a substantial portion of the revenues and earnings of the business.

A Due Diligence report is an extended version of the Quality of Earnings report, and includes a detailed review of tax records and past filings to uncover potential tax exposure and tax risks, as conducted by a team of tax professionals.  Furthermore, this may include additional procedures including regulatory and legal compliance review, which is meant to mitigate the risk of unknown liabilities and other potential exposure.

The level of due diligence varies on a case-by-case basis, as it is meant to be proportional to the size and potential risk of the transaction in consideration. Whether a business is being acquired or sold, due diligence procedures can provide vital information to assist with the completion of a transaction, and may avoid potential pitfalls that can be damaging, or even catastrophic, for the parties involved.

GG Observations

Our team of corporate finance and tax professionals have the pedigree 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.

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