Key areas overlooked in a due diligence review

Due diligence is an exploratory process to get to know as much as you can about a business and understand what actually exists. It’s not just about reviewing a few files in a data room and re-presenting the financial statements.

Successful acquirers are not looking to buy a P&L, a balance sheet and a cash flow, they want to understand a target’s potential and identify areas of vulnerability. In our experience, the key areas that can be overlooked as part of a due diligence review include:

1. Cashflow. It is vital to review the sustainability of cashflow as it is the single largest value driver for most businesses. EBITDA can be used as a high level indicator of cashflow but is by no means a thorough tool when making an important investment decision. For instance, EBITDA does not take into account any capital expenditures, working capital requirements, debt payments or taxes. It is essential to fully understand the movement of cash balances between periods.

2. Supply and demand. A company’s future growth depends on its relationships with customers and suppliers, but all too often these relationships are neglected in the due diligence process. It is important to determine why customers do business with the target, and how predictable their revenue streams are. Any customer who represents more than 10% of revenues or profits should ideally be covered by a long term contract. A thorough review of the seller’s supply chain is also required to identify any dependencies or potential savings.

3. Barriers to entry. Any unique products, services or distribution systems which limit competitors taking a market share need to be scrutinised in detail.

4. Management. It’s tough to place a high value on a business which is reliant on a sole decision maker. The management team in place at a target needs to be scrutinised to ensure they have the depth to run the business, and that procedures are put in place to retain talented management teams post acquisition.

5. IT systems. Information is the lifeblood of most organisations and integrating two companies’ information technology systems can be costly. Due diligence should determine whether the seller’s IT systems are compatible with the buyer’s system or what interim measures need to be introduced in the short term.

6. Hidden liabilities. Hidden liabilities can quickly erase the value of an otherwise promising transaction. It is not only important to review potential tax liabilities but also thoroughly analyse and evaluate potential exposure to other liabilities such as environmental risks or employee legal claims and, if necessary, adjust the purchase price mechanism accordingly.

Effective due diligence is about balancing opportunity with informed scepticism. It is about testing every assumption and questioning every belief. At Moore Stephens, we look beyond the numbers and focus on areas that will actually add real value to an acquisition process.

For more information, please contact Philip Bird.

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