Financial due diligence for SME acquisitions

Financial due diligence is the opportunity for Buyers to properly understand a target business’ earnings and cash flows, validate purchase price assumptions and to identify any financial ‘red flags’.

There are typically further complications in the SME environment as there may be less sophisticated accounting and reporting processes which creates challenges with information quality and availability. Below are some common areas that deserve attention in any SME due diligence based on our experience.

Is revenue recognised correctly?

Getting comfort that revenue is correct is critical as this impacts earnings which influences the purchase price. This area may need more attention if there is an element of revenue invoiced in advance of the service being performed or where customers pay upfront deposits. Other areas to examine include period end cut-off of billings and treatment of accrued revenue.

What is the normal, sustainable earnings of the business?

Be sceptical of earnings adjustments presented by the Seller as these are likely to present an overly positive view of the business, particularly if normal operating expenses like bad debts or foreign exchange losses are proposed adjustments. Also be mindful of any impacts on earnings that require judgement – for example, raising or release of provisions or capitalisation of staff costs. Any connection the owner or related family members have with the business should be examined. Also important are the intentions of the Buyer post-acquisition to install new management or rectify any gaps in finance resources. These additional costs should be considered in normal business earnings.

Watch-out for hidden liabilities

The condition of existing fixed assets required to run the business should be considered with a view on whether any catch-up capital expenditure is required to replace or improve the condition of existing assets. Buyers should be wary of aged assets and any deferral of capital expenditure, particularly in the lead up to the sale process. In addition, dilapidations under property leases are typically not accounted for by SMEs but will need to be investigated to ensure the Buyer is protected from any subsequent cash obligation.

What is the quality of working capital?

Working capital represents short term cash flow to operate the business. The Buyer wants to acquire a business with ‘normal’ working capital but the definition of ‘normal’ can be subject to significant discussion and debate.

A stocktake at (or close to) completion date is advisable to confirm the amount of stock being acquired and also to give some comfort over the condition of stock held. If there are concerns about the saleability of obsolete or aged stock, a methodology to calculate a reduction in stock value should be agreed.

There should be a focus on any deterioration in trade debtor collections, long outstanding and problem debtors. The Buyer should receive protection from any doubtful or long outstanding debtors. Any indication of stretching trade creditors beyond standard payment terms should also be considered with the Buyer being compensated for any ‘out of term’ creditor balances as a reduction in the purchase price.

Over the last year, James Cowper Kreston’s Corporate Finance team has performed acquisition and pre-financing due diligence on SME targets for a number of clients including Sovereign Capital, Piper, Foresight, Panoramic, Percipient, YFM, HSBC and NatWest.

For more information on this topic please contact Brad by using the details listed above or by submitting an enquiry.