Buying another company can be a risky business, but also brings exciting opportunities – so how do you make sure you know what you’re getting into, and that you pay a fair price?
‘Due diligence’ is the process of identifying a business’ assets and liabilities, and evaluating its commercial potential. In a nutshell, it is this process which will bring to light any risks associated with the purchase of the business in question, including whether the price you have agreed is a fair price. If you pay too much this may prevent you from being able to add further value to the business and reduce your chance of success; equally, underestimating the value of a business could result in a missed opportunity to acquire a business with real potential.
In this article, we will explore various elements of conducting due diligence and highlight its importance in the acquisition process.
Before we get into the detail though, it’s worth noting that there are several advantages to using independent advisors to undertake the due diligence work:
– Objective evaluation: Independent appraisers provide an unbiased assessment of the business
– Professional expertise: Independent advisors bring specialised knowledge and experience.
– Risk and opportunity identification: Appraisals help identify potential risks and opportunities
– Validation of financial statements: Independent appraisals validate the accuracy of financial statements on which valuations are often based
– Legal compliance: In some cases, legal requirements necessitate independent appraisals
What are the key elements of due diligence?
1. Thorough review of the financial statements
Financial statements, including the income statement, balance sheet, and cash flow statement, are critical tools for understanding a company’s financial health and performance. Analysing these statements helps buyers determine profitability, liquidity, and overall financial well-being.
As part of this review key financial indicators will be used for an assessment of the company’s financial condition and overall performance. These will include:
– Revenue growth: A successful business demonstrates consistent revenue growth over time
– Profit margins: High profit margins indicate a company’s ability to generate profits; a comparison of gross margin to net margin allows understanding of the key cost drivers in the business
– Return on Investment (ROI): A high ROI reflects strong returns on investments within the business
– Debt-to-equity ratio: This ratio reveals the company’s reliance on debt financing
– Cash flow: Healthy cash flow indicates financial stability and liquidity
During financial statement analysis, it’s essential to watch out for common red flags that may indicate underlying issues. Some more common examples of these as follows:
– Unusual accounting practices: Irregular or unusual accounting practices may signal financial reporting problems, for example, modifications to accounting policies or aggressive revenue recognition
– Deteriorating revenue or profit margins: A continuous decrease in revenue or profit margins may indicate ongoing issues which will ultimately impact profitability
– High debt or liabilities: Excessive debt can pose challenges in meeting future financial obligations
– Overstated assets or understated liabilities: These issues can misrepresent a company’s financial status
– Unexplained fluctuations: Sudden changes in financial metrics may indicate reporting inconsistencies
Identifying these red flags helps buyers make informed decisions about a business’s value and whether additional due diligence may be required.
2. In depth review of the business
Other areas of the business will be considered to get a complete picture of the company’s operations as well as its financial performance. This will include:
– Legal and compliance review: Any licences, contracts and permits as well as a consideration of any claims against the company
– Intellectual property searches: Confirm any trademarks, patents and copyrights are fully protected
– Customer and supplier contracts: Including the terms and conditions to ensure any potential risks are identified
– Employee contracts: Check that these comply with rules and regulations, and consider if any non-compete clauses are in place which could form a risk should there be any key employees
– Review of operational processes: An insight into where efficiencies could be made as well as any potential problem areas
– Marketing and sales: The company’s marketing approach and risks to reputation
3. Industry research and its importance
Researching the industry in which the company operates is essential for understanding market dynamics, competition levels, and growth potential. When considering an acquisition it is important to:
– Identify potential risks and opportunities: For example, changes in consumer tastes, developing technologies and growth in the industry and as to whether these are opportunities or threats
– Market trends: Research into the market for the various product lines as well as gaps in the market which could be exploited
– Understand the competitive landscape: Who has market share of the industry to assess the company’s position within the sector
– Benchmarking: Industry benchmarks for financial performance may be available; buyers can compare financial performance to industry averages and use this information to assess the purchased business’s potential for growth.
Negotiation
Independent assessment findings from the work undertaken above serve as an unbiased opinion on both the current position of the business and future opportunities.
The buyer can use the findings from the due diligence process to bargain for a lower purchase price if they think the company is overvalued. This will ensure they do not overpay for the business based on both its current performance and potential growth.
Conclusion
Thorough due diligence is vital when acquiring a business, and should include a comprehensive review of financial statements, market research, and other risk factors. Collaborating with specialists, such as accountants and solicitors, , will help you make well-informed decisions and avoid costly mistakes. It is importance to approach the assessment process with an open mind, considering various viewpoints and review techniques, to ensure a fair purchase price and a successful acquisition.
If you’d like to discuss this further, please contact your relationship partner or one of the Sowerby team.
Published by Sowerby Chartered Accountants, November 2023