Financial Due Diligence - Reviewing the Key Issues
Author: Pat O'Reilly
Time spent performing financial due diligence is rarely wasted but what are the key issues to consider? Pat O’Reilly offers some practical advice.
The primary objective of financial due diligence is to confirm the reliability of the information, which will be used in making an investment decision. Any changes in these primary assumptions may have a significant impact on the pricing or may even question whether you should proceed with the transaction at all. Time spent performing a due diligence is rarely wasted and at worst, will provide useful additional information about your potential investee. Set out below, are a number of issues, which often arise from financial due diligence and should be carefully considered when reaching a final 'go/no-go' decision on a transaction.
NON-SUSTAINABLE HISTORICAL EARNINGS
Audited financial statements are prepared only to comply with statutory and tax requirements or for a general purpose use rather than for your specific transaction. To understand the reality behind the reported numbers and the true quality of earnings, an in-depth review of the business and detailed management accounts must be performed. Adjustments need to be made to reflect the business you intend to acquire as it currently stands. Common adjustments include stripping out the impact of one-off events, lost customers, discontinued products, changes in cost structure and accounting errors. Traditionally you may have been valuing a business looking at cash flows and maintainable earnings however, there may also be a need to evaluate non - financial information such as the quality of risk management, the quality of management, corporate governance and the social and environmental performance of the company.
POOR QUALITY FORECASTING
The forecast may be prepared on a high level basis with oversimplified assumptions and no clear plan as to how the forecast will be achieved. Assumptions may be internally inconsistent and difficult to reconcile to historical results. Overall, the forecast prepared is often limited in its usefulness and normally would not be relied upon, particularly in forecast earnings based valuation model. See forecast model above.
POOR QUALITY OF REPORTED ASSETS
Frequently, write-offs for aged debtors, obsolete stock, idle assets and inappropriately capitalised costs need to be made. As part of the deal negotiations, it should be made clear which assets are to be included in the transfer and agreement reached over the valuation of these key assets.
UNDISCLOSED OFF-BALANCE SHEET LIABILITIES
With an increasing trend of revenue audits, there is a risk that pursuit by the relevant tax authorities could result in substantial hidden liabilities, penalties and exposures. In some cases, the quantum of the exposure combined with the risk of crystallisation may result in deal breaker issues. You may seek to protect yourself by obtaining warranties or indemnities against future potential tax issues.
TRADING PERFORMANCE DISTORTION
The importance of understanding the nature and extent of related party transactions cannot be underestimated as such transactions will often be conducted under special pricing terms. It is common to find that certain infrastructure such as business support services have not been charged by its parent or group company to the target business at all. For all related party transactions identified, the impact on the business of a change in ownership structure should be assessed, as detail is often necessary to adjust those transactions to reflect normal commercial terms. Identifying all the related party transactions in a business may not be straightforward as it is not uncommon, especially in mid sized or smaller private companies, for key management to have undisclosed competing business interests.
WEAK CONTROLS AND REPORTING PROCESSES
The lack of high quality timely information does mean that an additional investment in a new system may be needed to obtain the quality of information needed to properly monitor your investment's performance. Such changes do not happen overnight and there may be a need for agreement early on as to what can be reasonably achieved and a timetable which local management commits to. Furthermore you should ensure that the right staff are locked in for an appropriate period of time.
TAKING A
BALANCED VIEW
Failing to look past the issues to take a balanced view by weighing the risks against the upside potential is a common problem. Upside potential could range anywhere from synergies and an optimal financing structure to identifying opportunities such as access to new markets or a new management team. The upside potential and downside risks of a deal should always be viewed together rather than in isolation.
TAX STRUCTURING
Failure to plan and structure transactions in the most tax efficient manner diminishes or destroys anticipated increases in shareholder value and can lead to tax leakage and loss in management and staff incentives. It may also result in opportunities for optimising the new group's tax position being missed and delayed integration. Effective tax planning is the key component in delivering value as quickly as possible.
CONCLUSION
In all cases, the primary objective of due diligence is to confirm the reliability of the information provided. To put it simply, are you buying what you think you are buying? Any change in these preliminary assumptions may have a significant impact on the pricing, or may even question whether to proceed at all.
Due diligence can help identify the target companies non - financial information, future potential tax issues, revenue streams, market potential, maintainable earnings, future cash flows, operational issues, controls and any potential synergies arising from the deal. In a world where directors are continually being asked to defend their decisions months, even years after the fact, due diligence helps reduce the risk of making poor or uninformed decisions.
Pat O'Reilly is Transaction Services Senior Manager with PricewaterhouseCoopers. Email:pat.oreilly@ie.pwc.com