Purchasing a business involves considerable personal, professional and financial investment. For those considering a business transaction, it is important to know that academics and researchers highlight a discouraging trend for failed mergers and acquisitions. It’s sad, but true –— not all M&As are winners. However, the risks and surprises associated with the purchase of a business can be mitigated with the most vital tool of any successful M&A strategy — a comprehensive financial due diligence.
Business synergies are often the key motivators for any M&A. Such synergies may include cost savings, increased market share or expanded product offerings. While no two M&As are the same, all M&As share complexities that must be carefully strategized and executed in order to realize desired business synergies. Financial due diligence is an extensive analytical process that incorporates a variety of quantitative and qualitative procedures. At minimum, for a buyer to verify their assumptions and confirm a target’s claims, procedures that address the following financial elements are recommended:
- Review and confirm historical revenue and earnings,
- Inspect and confirm reported tangible and intangible assets,
- Investigate possible commitments and contingencies,
- Analyze the company’s quality of earnings,
- Evaluate the company’s net working capital, and
- Determine the company’s viability and value.
As an example of the insights available from financial due diligence, let’s dive into the concept of net working capital. In an M&A transaction, net working capital is a valuable financial metric for buyers and sellers. Net working capital measures the target’s ability to support day-to-day operational obligations. In its simplest form, net working capital is calculated as current assets minus current liabilities.
Be aware! Net working capital analyses can get tricky.
For example, in some circumstances net working capital can be adjusted to exclude cash and debt or to address non-operating and non-recurring items. Net working capital might also be modified to reflect anticipated future balances. However, a potential buyer’s evaluation of a target’s working capital does not end there. The financial due diligence process should also incorporate the other working capital metrics of days sales outstanding (DSO), days inventory outstanding (DIO), Days Payable Outstanding (DPO) and cash conversion cycle (CCC).
These metrics provide insights into how efficiently a target manages its cash and will assist in answering questions such as, “Does the target have strong customer credit policies?” “Is there a chance the target has obsolete inventory?” and “Does the target leverage vendor relationships to free up cash?”
Furthermore, the CCC, also known as the working capital cycle, is an especially insightful metric when assessing changes in working capital and liquidity. Essentially, the CCC is the length of time the target requires to finance its own day-to-day operations. A potential buyer should monitor the CCC throughout the due diligence process — keeping an eye out for shifts and swings in the metric that may suggest a need to get answers to these questions: “Has the target revised their credit policies?” “Did the target make any adjustment to their inventory processes?” and “Has the target reported a change in vendor terms?”
Keep in mind, an effective M&A strategy does not solely rely on the numbers.
In addition to financial due diligence, those contemplating a merger or acquisition should ensure they have each of the following:
- A transaction team that includes internal management, attorneys, financial advisors, bankers and industry experts;
- An exclusivity agreement (also known as a no-shop agreement) with the target’s owners;
- Time to meet with the target’s key employees and system administrators;
- Opportunities to observe the target’s cultural and organizational fit;
- Copies of the target’s executed contracts, as well as details on any verbal agreements;
- An expert to advise on the transaction’s structure and tax implications; and
- A letter of intent that negotiates the terms of the transaction, including purchase price, method(s) of payment, indemnifications, representations and warranties.
Without a solid strategy, an M&A may fall short of success due to these typical transaction pitfalls:
Overpaying — When a potential buyer relies on unexamined or inaccurate financial and valuation information, the result could be a mistakenly inflated purchase price.
Overestimating synergies — If internal operations are not investigated, the potential buyer might make inaccurate assumptions regarding synergies and cost savings.
Poor integration — When cultures, systems and leadership aren’t taken into consideration or, worse, misaligned, the merger might struggle post-integration.
M&A transactions are intricate and complex. They require a great deal of expert knowledge. They also require the buyer and seller to adhere to best practices — and the secret weapon within these best practices (one sure to prevent buyer’s remorse) is a quality financial due diligence. Simply put, financial due diligence, completed by an experienced, independent team of professionals, will give potential buyers the confidence and information they need when contemplating a purchase.
Rachel E. Biro, CPA, is a senior analyst at REDW Advisors and CPAs, one of the Southwest’s 10 largest advisory and CPA firms, also recognized as No. 112 on INSIDE Public Accounting’s Top 200 Accounting Firms in 2023. In her role, Biro provides clients with skilled valuation, forensic accounting and litigation support services.
