Here’s a comprehensive guide. Everything you need to know
In this article, I am going to share with you aspects that we (investors and associated advisors) typically ask about your financials when buying or investing in a company and what we are looking for from the counterpart.
At the end of this article, you will know
- What type of questions come up
- What data we are looking for
- Why we ask these questions
- What we intend with these questions
Stay with me and let’s get started.
Starting point: new questions
A typical thing during a financial due diligence is asking questions. Many questions. Depending on the due diligence, there are legal liabilities attached to the correctness of the report, but I’ll exclude this aspect here. We need to clarify strange movements in the financials, identify distortions, and remove them to have a clear view of the numbers. That is — in general — the starting point of asking new questions. Here’s a sample of questions that we could ask (even though they do not always contain a question mark):
- How much time does the monthly closing take?
- Please provide a reconciliation of the figures in the management reporting to the annual report.
- How reliable are intra-year financials?
- What accounting treatment is applied for foreign exchange gains and losses?
- Please provide a split of account number 123456 to understand the increase from FY19 to FY20.
- Is there any annual salary increase and if so, what’s the average increase?
- Have there been significant changes in accounting policies that affected your income statement?
The reasoning behind these questions
Let’s have a look at 12 selected topics to understand the reasoning for asking questions.
(1) Business drivers
To understand the market, the historical and projected growth, and the competitive environment, it is paramount to understand historical and future business drivers. For an automotive supplier, drivers could include the number of vehicles sold and the number of vehicles that are expected to be sold in the future. For a social media content creator, a business driver could be the average time spent in social media. Business drivers differ from industry to industry and even within the industry, each company has a (slightly) different focus.
(2) EBITDA adjustments
I stated above that one of the objectives of a financial due diligence is to provide a clear view on historical and projected financials, typically until EBITDA or EBIT, being a close proxy for the cash flow.
Unfortunately, there are always distortions. For example, headhunter fees for hiring a new CEO, or the suspension of a social media account which accounts for a large portion of your sales. The first example represents one-off costs, the second example shows foregone revenue. Other examples include the reimbursement of expenses that have been booked last year or the shutdown of a production plant.
During a financial due diligence, we look for non-recurring, one-off, or out-of-period items to enable a like-for-like comparison between past and future financials. Also, we assess whether the business plan is “clean” or whether the starting point includes any of these items that should have been excluded.
(3) FX treatment
In globalized world, understanding FX (foreign exchange) treatment is crucial. Firms with a cross-border supply chain are often not able to manage all their income and expenses in a single currency. There might be a supplier in country A, an assembler in country B, and then the products are shipped to customers in country B, C, D, and E. Depending on the contracts, natural hedging (i.e. facing income and associated costs in the same currency) is not always possible. So, companies sometimes face fluctuations in revenue or EBITDA simply because of fluctuations in foreign exchange rates.
During a financial due diligence, we need to understand these movements in detail. Depending on the circumstances, these fluctuations will be considered within the EBITDA adjustments.
(4) Revenue / Sales
There are many dimensions to analyze revenue, typically revenue by country, by customer, by product, by sales agent, by sales channel, or by business unit. The main objective here is to ensure no dependency on one of these dimensions, i.e. customer A accounts for 90% of your revenue. Often, the main business drivers can be identified and assessed during a revenue analysis. When it comes to analyzing the business plan, it is crucial to contrast past and future developments to assess any shifts and understand the logic behind these shifts.
(5) Material expenses / Cost of goods sold
The logic behind this analysis is quite similar to the revenue analysis. First, components and drivers need to be understood. Second, major dependencies from suppliers and raw material prices need to be assessed. A major dependency on a single supplier shifts bargaining power towards the supplier, which would lead to higher purchasing prices. A typical dependency on raw material prices would be oil or gas. Here, it is also paramount to understand if any of those price fluctuations can be passed through to customers.
(6) Personnel expenses
The analysis of personnel expenses is not limited to the expenses but also includes the headcount development. Any acquirer or investor wants to understand the employee development by function and by nature and the associated costs and additional items (holiday bonus, Christmas bonus, overtime pay). In owner-managed firms, there is often no clear management compensation. Including a fictive management compensation might be an additional EBITDA adjustment, as a new owner could hire external management.
(7) Other operating income and expenses
Other operating income and expenses include, but are not limited to, office expenses, rent, vehicle costs, gas and water, consulting costs, and income and expenses from the sale of assets. Other operating income and expenses are typically a rich source for potential EBITDA adjustments. Another aspect is understanding to which extent these costs are fixed or variable, as this impacts the business plan analysis. Assuming these costs would be completely variable, they would increase perfectly in line with revenue. Assuming these costs would be completely fixed, they would stay flat across the whole period. Understanding this is paramount to assessing if the income statement is planned correctly.
(8) Current trading
The term “current trading” relates to the year-to-date results. Let’s assume, the target has provided an income statement per May 2021 and an estimate for the whole financial year 2021. This estimate has been prepared in December 2020 and has not been updated since then. Typically, we would benchmark this year’s current trading with last year’s current trading. Let’s assume this year’s EBITDA per May 2021 is $50 and the estimate is $100, meaning that the EBITDA progression is 50% per May 2021. Per May 2020, the company achieved $40 EBITDA and the EBITDA of the whole financial year amounted to $60, hence 67% of the full-year result had been achieved per May 2020. The resulting question is then, why the progression is lower this year. Is the company doing worse this year and the estimate is too high? Or are there any items included that need to be adjusted? And if the estimate is too high, is the business plan then also too optimistic?
(9) Fixed assets
Fixed assets are the basis of operations of most companies. An automotive supplier typically has many machines and plants. When analyzing fixed assets, it is important to understand which assets there are, and what the current capacity, age, and utilization are. Also here, it is paramount to understand this to assess the business plan properly. If the company is currently operating close to full capacity and utilization, an increase in revenue will necessarily lead to investments into new plants, factories, machines, etc. Oh and by the way, also depreciation in the income statement needs to reflect these developments — which isn’t always the case 🙂
(10) Working capital
Working capital includes trade working capital (typically: inventories, trade receivables, trade payables) and other working capital (items required to run the firm). As part of the purchase contract, a normal/recurring level of working capital needs to be defined. Part of the due diligence process is to define which level is normal or recurring. Easier said than done. Companies aren’t stable. There are changes in payment terms, changes in the whole supply chain, there is growth or steady-state — so, what is normal? Assume a young company that exhibits double-digit growth. What would be a normal state of operations? Which level of working capital would be justified.
Another aspect to keep in mind: the definition of working capital differs for buyers and sellers. While a seller tends to define its working capital broadly, a buyer does so in a more narrow way.
(11) Net financial debt and debt-like items
Typically, net financial debt comprises cash and bank liabilities and any other financing agreements. During a due diligence, investors and advisors want to understand which assets should be classified as net financial debt and debt-like items and assess in detail, if there are any significant, but less obvious, debt-like items within other assets or liabilities.
(12) Sources and quality of financial information
The analysis can only be as good as the underlying data. I explained a lot about the different analyses and how to approach them. But all depends on the data quality ultimately. That’s why we typically include a chapter on the financial information, its sources, and the quality of the data. Any investor or acquirer needs to put the findings of the due diligence into perspective. Therefore, we need to understand the sources of financial information and check if they are consistent. Typical sources include management reporting, trial balances, and annual reports. Also, we need to understand significant accounting policies and their impact on financial statements. And lastly, we need to identify differences. For example, if the acquirer reports under US GAAP but the target under German GAAP, revenue recognition could differ, depending on the industry. Or the acquirer has another approach to depreciation than the seller.
- Understand the historical drivers and assess to which extent the projected performance differs from the past figures.
- Understand any distortions and assess to which extent the projected financials are based on a “clean view”.
- Understand the balance sheet and assess how the classify the items
- Understand the sources and the quality of financial information to assess the quality of the due diligence
With this quick overview, I intend to illustrate the main procedures of a due diligence process and why potential investors and their advisors ask many questions. I intend to provide the bigger picture to understand why we ask these questions. Please note that some aspects, like investment planning or cash flow and the business planning procedure, have been excluded for the sake of simplicity.