By Brandon Fredericks, CPA | AGP Advisory, Leader
In our third installment of this series, we want to get into the interworking of sound financial due diligence. We have already explained what high quality of earnings (QofE) can do, but what does a financial due diligence process look like for isolating and assessing earnings? All projects should focus on three key elements in this area
- Proof of cash à As we determine the trailing twelve-month time period, our first step is to ensure cash reconciles from one period to the next. Let’s be honest, if we cannot be confident on cash, can we even be confident?
- Revenue assessment à Next, spending time to properly assess their revenue recognition policy and how they apply it. Evaluating historical transaction against this policy and evaluating it against Generally Accepted Accounting Principles (GAAP) is paramount to ensuring earnings is correct.
- Analysis of operating accounts à Finally, spending proper due diligence determine if the beginning and ending balance sheets have been appropriate analyzed to determine if all revenue and expenses were properly accounted for in the correct period. Remember, in most cases our deals are in a trailing twelve-month position making recognition of revenue and timing of expenses very important.
Beyond isolating and assessing earnings, the net working capital cannot be overlooked in any transaction. Far too often we come across situations were significant additional spending is being conducted post transaction due to a net working capital issue. That should signify the importance of making this a centerpiece to any financial due diligence process. As the transactions we assist with all relate to private companies, the concept of net working capital is a significant component in any Letter of Intent (LOI) and/or purchase agreement. Here are some key points to keep in mind related to the NWC:
- Working capital has a potential for a dollar to dollar impact in the purchase price and therefore should be highly scrutinized in the due diligence process.
- A comprehensive and robust definition of working capital and indebtedness in the purchase and sale agreement reduces the potential for future litigation.
- Completing a full analysis of the working capital accounts will create a deeper understanding of the nature of each account.
- The accounting method used for the NWC should be clearly stated in the agreement.
- It is also highly recommended to include an example or sample schedule for NWC to give further clarity.
The importance of sound practice around isolating earnings and understanding the working capital cannot be just limited to this one page; however, hopefully by understanding these steps further best practices can be put in place for your transaction.