Balance Sheet Due Diligence and Validating Financial Position
By Derek Oster, Manager, Valuation, Forensic & Litigation Services
What first comes to mind when you hear the phrase “quality of earnings?” Is it income? Expenses? Normalized EBITDA? In a due diligence process, chances are this phrase evokes a focus primarily on a company’s income statement. On the other hand, a company’s balance sheet is often considered secondary when the focus is a quality of earnings analysis. However, to properly ensure that the benefit stream and EBITDA generated by a target company is reliable, it is important to consider the impact that the balance sheet can have to a company’s annual earnings. Due diligence procedures related to the balance sheet also play a crucial role in evaluating the current and future financial health of a target company.
In order to validate both the quality of earnings and the balance sheet, the following accounts are typically considered, analyzed and discussed with the target’s management during the course of financial due diligence:
- Cash and short-term investments: While transactions are commonly structured on a cash-free, debt-free basis, it can be important to understand a target company’s cash management and treasury function, including deposit and disbursement practices, banking relationships, reconciliation process and more. In addition, performing proof of cash analyses, analyzing financial derivative contracts, understanding and reviewing cash flow and operational funding capabilities also play an integral part in understanding the target company’s overall cash and short-term investment techniques.
- Accounts receivable/accounts payable: It is important to review aging and bad debt statistics, especially balances aged 90 days or greater, as this will uncover any historical issues with receiving payments from customers or vendor disputes. In addition, due diligence procedures related to accounts receivable and accounts payable include:
- Inquiries into the collectability of large overdue balances prior to closing dates
- Billing and credit policies
- The basis for, adequacy, and consistency of reserves for bad debts, returns, discounts and other allowances.
These procedures ensure that revenues recognized previously are truly collectable. They also help the buyer understand the target’s collection patterns, and they reveal any disputes on invoices that need to be resolved prior to closing.
- Inventory: When acquiring a company that maintains inventory, it is essential to analyze the historical, current and expected levels of inventory on the target’s books. Inquiries related to aging help identify any excess or obsolete inventory, which can often overstate acquired inventory levels and subsequently affect net working capital target amounts. Ultimately, inflated inventory may adversely impact the company’s ability to meet product delivery post-transaction. Moreover, analyzing the historical and expected levels of primary components of inventory (e.g., raw materials, work-in-progress, finished goods) helps a buyer understand the inventory turn cycle and identify seasonal or cyclical variations.
- Related party assets/liabilities: For working capital purposes, identifying and analyzing amounts due from or due to officers, directors, stockholders, employees, affiliates or other related parties is important to understand. Typically, the goal is to present the target company’s financial position as if it were on a stand-alone basis, or to be consistent with what is expected on a go-forward basis subsequent to the closing of the transaction. Many privately-held companies utilize shareholder loans or receivables for a variety of reasons, so it is important to understand the nature of these accounts and determine if an adjustment should be made. Often, these types of assets or liabilities are in plain sight, while in other cases these items might be buried in other assets or liabilities. Discussions with management by your due diligence provider can help identify these and ensure they are treated properly in the transaction terms.
- Prepaid expenses/accrued liabilities: It is common for privately held middle-market companies to only review and adjust prepaid expenses and accrued liabilities at year-end as opposed to doing so more frequently (e.g., monthly or quarterly). In most cases, this approach is the result of the limited time and resources available to smaller companies that would allow them to complete a formal monthly “hard close.” As such, a due diligence engagement performed as of an interim period may create exposure due to unreported prepaid expenses and accrued liabilities. In these cases, additional analysis may need to be performed to ensure that the interim period EBITDA is complete and accurate, incorporating proper adjustments to these balance sheet accounts. Typical due diligence procedures related to prepaid expenses and accrued liabilities consist of:
- Inquiries surrounding the accounting policies
- Timing of the conversion of these balances into cash
- The basis for and adequacy of accruals
- Consistency of the prepaid expenses and liabilities
- The nature, movement and impact on earnings of significant accrued liabilities and reserves
- Fixed assets/capital requirements: When evaluating a target company, it is also crucial to consider the fixed assets and capital investment requirements of the target company that are necessary to properly operate the business. A company’s book value may not fairly reflect the market value of its real or personal property. Furthermore, the target may require immediate additional investment to continue to generate the cash flows the company has realized in the past. As such, due diligence procedures related to fixed assets identify these potential issues or unknown items. For example, those procedures may include inquiries surrounding accounting policies for fixed assets (e.g., capitalization, depreciation, impairment), the date and results of the last physical counts, excess or idle property (including property that has been written off or requires replacement sooner than originally anticipated) and significant gains or losses on dispositions. Moreover, it is important to make inquiries related to capital expenditure history and projected capital investment requirements such as historical budget-to-actual analyses, individually significant capital projects and any related purchase commitments. This analysis can provide a better understanding of the company’s fixed asset position along with a preview into what expenditures might be necessary on a go-forward basis.
- Debt: As previously discussed, transactions often are structured on a cash-free, debt-free basis. That said, due diligence procedures related to an analysis of a target company’s debt position are also important with respect to understanding the company’s current leveraging capabilities. Procedures and inquiries related to debt can consist of:
- A review of debt agreements to identify any significant change of control, prepayment or other significant provisions
- Past due amounts
- Actual or potential covenant violations (including consideration that a proposed transaction could have)
- Terms of debt agreements (such as future payment requirements).
Insight into future payment requirements can be of particular import to a buyer, as quantifying the post-transaction cash flows provides valuable decision-making information in terms of how operations will look going forward. It can also help determine the capital available for additional reinvestment, distribution to owners or other options.
- Other assets, other liabilities, and off-balance sheet items: It is important to identify and analyze any additional non-operating assets and liabilities, as well as perform inquiries to determine if any material off-balance sheet items exist, including operating leases and outstanding litigation which impact the target company’s cash flows post-transaction.
A fundamental understanding of a company’s balance sheet can provide important insight in evaluating the feasibility of a transaction as it ensures the whole picture of a company’s financial health is known and understood. Whether you seek to purchase a business or explore sale opportunities, you should be cognizant of the impact that balance sheet components can have on the value of a business and its EBITDA.