Ahead of a big acquisition, most executives would agree that it’s important to scour the books for any signs of concern. The problem is that it’s hard to see red flags through rose-colored glasses, and many buyers miss major issues.
Just ask Hewlett-Packard. The long-standing tech company recently went to court with former executives of Autonomy over claims the CEO and CFO overstated Autonomy’s value by more than $5 billion in its 2011 sale to HP.
If $5 billion can escape the notice of one of the most successful companies in the world, you’d better believe it can sneak past less-trained eyes.
The costs of a bad buy
When it comes to buying another company, you don’t know what you don’t know. Without recognizing what to look for (and having the right team to help you), the mistakes can be costly.
Those costs might affect you, your family, your business, or all of the above. Whether it’s a credit nosedive, long-term financial struggles in your company, or losing your life savings, the impact can be devastating.
I recently watched firsthand as one family dealt with the heartbreaking effects of a bad sale. The father sold the business to his sons, planning to use the money from the deal to support his retirement. The price he charged, however, was more than the business could handle, and the company started failing. The sons were barely making a living wage, and their father faced the possibility of losing his retirement income.
There were no red flags in the financial statements. But the company just could not support the debt created by the sale.
Breaking down the books
So how do you know what to look for to prevent these pains? When examining the financial statements of your prospective acquisition, start with these five areas:
1. Favor accrual over cash accounting.
Cash may be king, but not in accounting. Cash accounting allows the seller to easily manipulate the books by not clearly defining the true sales and expenses of the company. This could inflate the company’s net income.
Accrual accounting, on the other hand, clearly tracks accounts receivable and accounts payable. This gives the buyer a clear view of the company’s debts and expected revenues. It provides a fuller picture of the overall financial state of affairs, and the remaining areas we’ll look at depend on this method.
2. Examine accounts receivable.
You can glean some critical insight from looking at the company’s accounts receivable statements. In particular, you’ll want an aged accounts receivable listing, which is something only a company running on accrual accounting can provide.
That aged listing will show you two key things. First, look at the customer spread. Even if the owners don’t want to share specific names, you should be able to see whether they heavily depend on just a few customers. Typically, 20 percent of a company’s customers account for 80% of its business. If a lower percentage accounts for that much or more of the sales, be wary. What happens if you lose just one of those major customers?
Second, the accounts receivable listing will show you whether customers are generally paying on time. Late-paying customers are a headache you don’t want to inherit, and they are likely to leave if you start enforcing payment terms.
3. Inspect accounts payable.
You can pull similar information from the company’s payables. Like an imbalanced customer roster, an overly concentrated vendor list raises concerns. What will it mean for your business if you lose the supplier who provides most or all of your goods? Diversity is key.
You’ll also want to look at the company’s typical payment time frames and past-due balances. A high days payable outstanding isn’t necessarily bad — it can mean free cash flow and varies a lot by industry. But timelier payments might garner discounts and good favor with vendors. Never assume that a bad reputation will be wiped clean by a change in ownership.
4. Look for inventory movement.
When it comes to inventory, it’s all about movement. If you look at three to five years of financial statements (yes, always ask for this much) and see no significant fluctuation in inventory, something is fishy. Most likely, the company is simply not counting it.
Uncounted inventory can lead to overstated inventory. And overstated inventory leads to an understated cost of goods sold, which leads to overstated gross profit. See where I’m going here?
Make sure that the inventory on the books reflects the real inventory on hand and that what’s there is actually sellable. If the bottom line is inflated by inventory inaccuracies, it’s time to hit the brakes.
5. Compare financial statements and (official) tax returns.
Once you’ve done a thorough review of the company’s financial statements, you should compare them to its tax returns. And not a copy of the returns, but the real deal. I have personally seen owners furnish fake, never-filed tax returns. To avoid this, have the seller sign an IRS Form 4506-T, which enables you to get returns directly from the IRS.
The returns might not match financial statements precisely, but they should be fairly close. Have your CPA review all of these documents to verify the accuracy and validity of everything. As with everything in this process, a solid advisory team is critical to ensure you’re not missing anything.
When you get a clear view of a company’s financial statements, you’re seeing the heartbeat of that company. A few red flags might not mean an imminent heart attack, but it might signal some health issues that could at least change the sale terms.
If you’ve reviewed these key parts of the financial statements, you’re off to a solid start. That due diligence, along with some outside perspective, can help you ensure excitement isn’t clouding your judgment.
(Featured image by DepositPhotos)
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation for writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
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