The following is a guest post from Bill Chapman, principal at Baker Tilly and a managing director of Baker Tilly Capital. Opinions are the author’s own.
There have been many academic studies about the failures of mergers and acquisitions. The reasons transactions fail to meet expectations can range from poor initial concept to poor integration execution. However, one mistake that frequently appears in these studies is weak financial due diligence by the buyer and their advisors. The following ten items highlight areas where quality of earnings studies often fail to assist the buyer in validating their investment thesis.
1. Focusing only on EBITDA
Buyers and sellers often forget what quality of earnings means. An earnings metric is considered of high quality if it reflects sustainable free cash flows. While earnings before interest, taxes, depreciation and amortization (EBITDA), adjusted for non-recurring expenses and revenues, are critical, they are not the only component to consider.
The cash flows available to debt and equity stakeholders, commonly referred to as free cash flows, are a key metric. EBITDA alone can be easily manipulated. Sustainable free cash flows should form the basis for validating any investment thesis. Debt funds, for example, underwrite credits based on free cash flows. While covenants may be described in terms of EBITDA, the decision is ultimately based on free cash flows.
2. Not deconstructing the financials
Accountants and auditors are charged with the task of summarizing financial data so that a layperson can better understand the subject company’s financial position and performance. However, in due diligence, one cannot simply accept the financial statements at face value. The investor (or their representatives) must deconstruct the financials to obtain a clearer view of what really happened. Such tools might include comparing financials, month by month, at the general ledger account level. The purpose is to search for anomalies at the most granular level of the financial statements — expense and revenue stops and starts, peaks, valleys and debits where there should be credits, etc. This analysis does not answer any questions but instead raises questions.
3. Incomplete management interviews
While the due diligence team will have access to the management presentation slide deck and the confidential information memorandum, it is important to note that these are marketing documents and may not fully present relevant information for the due diligence team. As a result, the management interview is critical and should cover areas such as company history, operations, accounting policies and procedures, personnel, product, services, vendors, customers, distribution channels, pricing strategies, industry structure, competitive landscape, etc.
The answers to these questions can then be compared to the financial discussion. Are there any inconsistencies? Does the overview of the business presented by management confirm or conflict with the financial results? The diligence team must remember they are every bit as much of a financial analyst as they are accountants. Looking for inconsistencies can lead to interesting revelations about how the company was managed.
Management may try to rush through the interview, providing overly simplistic or vague answers. Responses like “we set our price to the market”, “our sales are up because our customers ordered more” or “the only thing keeping us from selling more is the availability of product” are often meaningless. The diligence team needs to utilize a “root cause” approach that is a part of the Six Sigma program (ask ‘why’ five times) to get the genuine answer.
4. Not fully accessing the risk profile of the subject business
To determine how sustainable the economic earnings of a business are, the decision maker should consider all the risks that may threaten the stability of those earnings. Customer concentration is an obvious risk — what happens if a key customer leaves? However, several other risk issues should be considered as well, such as:
- SKU concentration where developing technology could create obsolescence or substitute products may become more appealing
- Commodity risks where a key raw material may become unavailable or is vulnerable to material swings in cost
- Vendor and supply chain concentrations where a union strike or tariffs could interrupt the favorable economics of a longer supply chain
Revenue and earnings volatility have always presented investors with problems by making reasonable predictability of cash flows more difficult. Assessing the seasonality and cyclicality of a business are two factors that need to be considered. Seasonality is easier to manage since revenue spikes and drops tend to follow predictable patterns (i.e., before the holidays). Cyclicality is harder to anticipate. Utilizing tools like an operating leverage analysis, one can at least reasonably estimate how sensitive cash flows are to changes in revenues.
5. Not reviewing the independent accountant’s work papers
Whether an audit or reviewing a tax return, the due diligence team should review the independent accountants’ work papers. These papers hold critical analysis and contain important judgment calls that could impact the analyst’s assessment of the economic earnings or provide insights that could speed the process. One such item to look for in the work papers is the passed journal entries. The materiality level in an audit is based on revenue and total assets, but for due diligence, the focus is on EBITDA, which is a much lower threshold.
What might not have been material for the audit may have been a potential EBITDA adjustment for the due diligence. However, the analyst should remember that changes in accounting methods may change EBITDA but will not change free cash flows. In addition to the passed journal entries, the work papers may reveal deficiencies or weaknesses in the company’s accounting policies such as inadequate segregation of duties and other internal controls. These auditor findings can lead the analyst to where the company is susceptible to error (or even fraud) and guide the diligence team to potential risk profile issues.
6. Not completing a proof of cash
If you cannot be sure of the cash, you cannot be sure of anything. The proof of cash process involves reconciling cash receipts and disbursements to the cash on hand. The results should be compared to the bank reconciliation prepared by management and then to the cash balances presented in the financial statements. All three should match within the materiality level determined by EBITDA. If they do not match, the process should be stopped until the matter is resolved.
Note that a complete proof of cash includes both the receipts and the disbursements. Too often we see just the receipts being considered by the due diligence team. Errors, omissions and irregularities happen on the disbursement side just as they do on the receipts side.
7. Confusing net working capital analysis with the net working capital mechanism
After EBITDA, the change in net working capital (NWC) is the next component of free cash flows. Unlike the normalization of EBITDA, NWC must be assessed by financial analysts for items that may be non-recurring or debt-like in nature (e.g., accrued interest expense, accrued litigation costs, etc.). The NWC mechanism standard, or “Peg” refers to the level of NWC that is determined by both parties to be delivered at closing. The Peg is a negotiated item, where the NWC is analyzed with the generation of free cash flows in mind. The difference between these two analyses is simple. The quality of the earnings team’s analysis of NWC for cash flow purposes is calculated, but the Peg is negotiated.
8. Confusing what a debt-like item is, and is not
Most debt-like items are obvious to the analyst — pending litigation, accrued interest expense, deferred compensation, etc. However, some liabilities, such as deferred revenue or customer deposits, may be harder to classify. Are they part of normal working capital, or are they obligations that need to be satisfied (e.g., in a cash-free, debt-free transaction)? Facts and circumstances will dictate here, and a lot will depend on the judgment of the diligence team. It must be remembered, however, that in such situations, these liabilities cannot be both debt-like and part of the net working capital.
9. Critique of the sellers’ projections
The buy-side diligence team should be looking for a full set of projected financials. The mechanics of the model should be verified, and the assumptions should be compared to historical results. For example, if the company has never increased net revenues faster than 7% in the last 10 years, but the projections show 15%, why? Days-in-receivables have never been shorter than 60 days, but the projections assume a 30-day collection period. Why?
Additionally, where possible, reliable third-party or industry data should be used to help validate the assumptions. If the assumption is the company will increase revenues 10% each year for the next five years, but reliable third-party reports indicate industry expansion of only 3% over the same period, the implication is that the company is taking market share. How and from whom?
10. Forgetting about operational taxes
Operational taxes can be defined as any tax or fee that is not calculated on net taxable income. Such taxes might include sales and use tax, real and personal property taxes, payroll taxes, unclaimed property subject to escheatment, etc. These taxes and obligations are important to consider as they are sometimes referred to as “sticky taxes” because they follow the assets. The structure of the transaction will not give the taxpayer (buyer) any relief when structuring the transaction to provide for an efficient income tax structure.
For example, sales tax (Nexus exposure) is a key issue that can affect the buyer if not addressed in the deal’s structure. If these operational taxes are not analyzed, the buyer could inherit liabilities that were not previously considered.
A quality of earnings study should never be the sole basis of making an investment decision. Other aspects of due diligence that should be considered may include: tax due diligence (federal, state, international and operational as discussed above), human resources (compliance, self-insurance, unions, etc.), information technology (cyber security, industry and regulatory requirements, etc.), commercial due diligence (quality of the customer, also known as voice of the customer), operations due diligence (supply chain efficiency and alternatives, etc.), legal and regulatory, environmental, appraisals, etc.
These are just a few issues that we have seen glossed over or completely ignored, to the detriment of the transaction’s success. There is no substitute for thorough due diligence. The buyers should take full advantage of outside professionals and fully utilize internal talent, especially those who will ultimately be responsible for managing and integrating the new operations.
