A lot of companies use Red Flag Alert when they’re looking to purchase another business.
Our detailed financial information and unique health-rating algorithm provides insight into the financial health of target companies.
We covered the whole process in our guide on commercial due diligence, and this article goes into further detail on the financial due diligence process.
Don’t Be Scared of the Due Diligence Process
Many entrepreneurs are deterred from acquiring businesses because of risk. They often don’t feel confident valuing a business accurately and believe they’ll miss key issues.
This is especially the case for small and mid-market acquisitions where financial information is less readily available, and company accounts are micro-entity or abridged versions.
Business acquisitions – or to use corporate-speak, ‘M&A’ – has been on the rise recently, according to the Office of National Statistics, but this data only covers deals with a value of £1m.
There are a large number of smaller deals where businesses are growing through acquisitions in manufacturing, construction, insurance and many other sectors.
Because these deals are smaller and there aren’t teams of accountants and solicitors to pore over financial statements – for a £300,000 acquisition the due diligence process has to be proportionate to the deal size.
This often leaves acquirers having to do a lot of the legwork themselves.
In this article, we’re going to demystify financial due diligence and give you some simple, easy tools to evaluate the financial viability of an acquisition target.
Your Financial Due Diligence Checklist
This financial due diligence checklist is designed to be high-level and ensure that you focus on key areas.
The crucial goal for financial due diligence is to (i) validate the information you are given, (ii) judge what the key risks are, and (iii) understand how well they can be mitigated.
1. Balance Sheet
2. Asset Valuation
6. Key Financial Ratios
7. Key Financial Risks
The balance sheet provides a snapshot of the assets and liabilities of a business, and tells you how it is funded.
All of these points are very important to understand and can be simplified in this equation:
Assets = Liabilities + Shareholders’ Equity
This shows that everything the business owns (the assets) is financed through borrowing (taking on liabilities) or investments (shareholders’ equity).
A key question to consider is whether the business is financed mainly by debt or equity and what that capital has been used to buy.
From this starting point, you can dig into the breakdown of those assets and liabilities.
You should consider what the business owns and the value of these assets. Some assets are relatively simple to price, like property or machinery.
You may be aware that the valuation of assets on a balance sheet might not reflect market rate.
For example, property may be valued at the book price (price paid less depreciation), or it may have been revalued and the balance sheet value may be more up to date.
It will depend on how the target company measures the value of an asset – you can read more here.
The key point as an acquirer is to ask how asset values were calculated, and for important assets you should verify those valuations.
Similarly, plant and machinery that have a specific use may be very valuable to a company, but the market value may be low because there would be very few buyers.
Be careful to check how much value is derived from goodwill – this is the excess paid by an acquirer for another business and if the price paid was too high, the goodwill won’t reflect the current value.
Stock and debtors should be analysed – stock can be overpriced, especially in certain industries like fashion where obsolescence is a common problem as trends move on.
Check the terms and conditions for liabilities the business holds. Businesses may have signed loans on poor terms that could have severe consequences if repayments are missed.
With some loans, you don’t even need to miss repayments to incur penalties. If a property has been used as security but reduces in value (not uncommon for commercial property), this can trigger penalties.
Check the charges that creditors have over the assets of the business; if repayments are missed, assets may be at risk.
Private equity has a reputation for imposing harsh terms on businesses, so be especially careful if there are outside investors like this.
Be careful to assess the strength of the liquidity of the business – poor liquidity can lead to a constant need to plug holes in cash flow, which is expensive, time-consuming, and often fatal for a business.
The ‘current ratio’ looks at a company’s ability to meet short-term obligations, and the ‘quick ratio’ does this by discounting stock.
Current Ratio: current assets / current liabilities
Quick Ratio: current assets – stock / current liabilities
Different industries will have different levels for what constitutes a good ratio. Take restaurants for example – data from Macrotrends points to the average restaurant current ratio being 1.1.
As we stressed at the start of this article, make sure you contextualise this figure because every business will be different.
The key question is: are you comfortable that the business can weather the storm if there is a problem with cash flow, such as a downturn in revenues or a big outlay?
Two key performance indicators are revenue and, most importantly, profit margins.
You need to look at the company’s financial statements and past performance to determine the trend of these key metrics and then try to determine the likelihood that these trends will continue.
Revenue and margins may have been stable for many years, but this may be due to one key contract or the very specific skill-set of an owner who won’t be around post-sale.
What you are looking for is diversified income streams, robust processes that don’t rely on outgoing owners and a marketplace that is likely to sustain these sales.
Key Financial Ratios
We’ve already looked at a few financial ratios, and there are many you can use as part of your financial due diligence checklist.
It’s a worthwhile starting point to look at some of the key ratios – here is a list.
The important thing to note is that this is a starting point – every business and every industry will have different optimum ratios. You should be looking for where you can add value.
A business may have poor liquidity but strong sales and assets, so you may spot an opportunity to improve liquidity with invoice financing.
This may increase the speed that cash flows into the business and mean more sales will be made in a certain period – supercharging growth.
Key Financial Risks
Financial due diligence is a form of risk mitigation.
You should constantly be validating the information you receive and asking what is the chance of XYZ happening and what does that mean for my business if it does happen?
For example, if the business has one or two key clients what would happen if they left? This can be overlaid with the likelihood of it happening.
Once you have assessed the level of risk, you can see if it matches your risk appetite and subsequently whether the deal is good value.
High risk may not necessarily be bad news – it may mean you can negotiate a much lower price and you may have a great way to mitigate the risk.
If the risk is that the business relies on one key client, you may have great relationships with other potential clients and be able to quickly increase the client base and de-risk the deal.
How Red Flag Alert Can Help
If you’re performing financial due diligence in the UK, then Red Flag Alert is the best tool for you.
The Red Flag Alert value proposition is based on evaluating the financial health of every business model in the UK.
Data is collated from ten market-leading data sources before being put through our detailed algorithm that provides a health rating.
These health ratings are used to predict insolvency and are used by over 1,000 companies across the UK to manage credit risk.
Along with detailed financial health ratings, Red Flag Alert provides:
- 100,000 data changes every single day
- Financial ratio analysis and company accounts
- Historic performance data
- Key director details
- Contact information
- Details on charge holders
- A list of bad debts