The financial review is an initial exploration, based mainly on the figures from the information memorandum and financial statements of recent years.
Later, if you have serious interest in the business and you have a due diligence done, you will go into much more detail. Still, such an initial evaluation can teach you a lot.
By looking critically at the balance sheet and profit-and-loss statement, by studying historical figures, and by calculating financial ratios, you develop a feel for the business. How healthy is it? What is its potential? It also teaches you whether the numbers are polished.
Very important is to analyze the cash flow. In particular, the free cash flows give an indication of the earning capacity of the acquisition target. The following items and ratios are important to take a closer look at:
We take a closer look at the main areas of concern:
#1 Normalization items
Financial statements from past years give a picture of the company's past. Usually the information memorandum also includes a forecast for the coming year(s). The annual figures are often normalized by the seller. This means that the official financial statements are adjusted for incidental and abnormal expenses. The advantage for the buyer is that the normalized financial statements are representative of the situation after the acquisition. This allows him to better estimate the value of the business.
Items for which adjustments are made include, for example, consulting fees due to putting the business on the market, or one-time moving expenses or double-paid rent related to a move. Revenue can also be normalized. For example, if a fire caused six months of production to go up in smoke.
All kinds of private matters are also corrected in the normalized figures, such as a management fee to the DGA that is higher or lower than usual. It may also involve receipts from the Makro or, for example, the purchase of a computer secretly intended for the children or 'office furniture'. Often, the DGA's car expenses are also normalized. After all, once he has left, these expenses are a thing of the past. Of course, your own car expenses will take their place, but the amount is up to you.
Tip: In general, assume that the seller will only include those normalizations that suit him and thus increase the profit and thus the value of the business. Items that are negative for the seller will only be included if they are very obvious, such as a very low management fee. A good, critical assessment of normalization items is always the first step in negotiations.
#2 Balance sheet items
Not only the profit and loss account, but also the balance sheet can be polished by the seller. Therefore, critically go through all items. Are the figures you are presented correct? A business often has hidden reserves. For example, the premises may have a higher economic value than reflected on the balance sheet. In this case, it is advantageous for the seller to revalue the property, because this improves the equity and solvency of his company. And that, in turn, benefits the asking price. As a buyer, you must ask yourself whether the revaluation is realistic - is it based on an appraisal report, for example - and whether a provision has been made for a deferred corporate tax claim.
A revaluation can also apply to machinery and inventory. Look at these critically as well. The same goes for the provisions. Are the provisions for such things as building maintenance, warranties and bad debts high enough? Special attention should be paid to pension provisions for personnel. This is a complex matter that requires attention from subject specialists. Also take a preliminary look at debts. What interest is paid on the loans? If you feel the interest rate is too high, how high are the costs of closing the loan?
Tip: During negotiations between buyer and seller, the accuracy of balance sheet items is a common point of discussion. Through warranty provisions, the buyer can ensure that he covers himself against surprises.
#3 Financial ratios
Financial ratios say a lot about the state of the business. There are dozens, if not hundreds of ratios; we will limit ourselves to a few important ones:
- Solvency
Solvency is equity relative to total assets (balance sheet total). It indicates the extent to which the company is able to meet its financial obligations. The risk of low solvency is that the business runs out of buffer. If things get tough, it immediately runs into trouble. A business with one and a half million in equity will survive a loss of one million euros. But a business with three tons of equity after such a loss will have negative equity of seven tons and be technically bankrupt.
- Interest-coverage ratio
The interest-coverage ratio indicates how many times a company earns its interest charges. This is a measure of how much profit (before interest and taxes) can fall back without the company getting into financial trouble. This key figure also indicates the extent to which the company can still take out loans, with their associated interest charges. A value higher than three is considered normal. Keep in mind that after the acquisition, the financing burden in the acquired business will increase, lowering the interest-coverage ratio. So this ratio is certainly also interesting to assess the post-acquisition situation.
- Inventory turnover rate
The success of businesses is increasingly determined by good inventory management. Excessive inventories cost money because they require storage space and have to be (pre)financed. They take up working capital, which could be better utilized. Furthermore, inventory is subject to spoilage, obsolescence and price reductions. The higher the inventory turnover rate, the better.
Inventory turnover ratio indicates how long inventory is stored in the warehouse. This ratio is calculated by dividing the cost of revenue by the value of inventory. The higher the outcome of this ratio, the shorter the stock is in the warehouse.
The reciprocal of this formula indicates the inventory turnover rate. It is calculated by dividing the value of inventory by the cost of revenue and multiplying that by 365. This value indicates how long (in days) stocks are stored on average. The lower the outcome of this fraction, the more favorable it is for liquidity.
- Turnover rate of debtors
Similarly, we can determine the turnover rate and turnover time for accounts receivable. The turnover rate involves dividing revenue on account by the accounts receivable balance. Turnover time involves the reciprocal of this calculation, then multiplied by 365. Turnaround time shows the average collection time (in days) of accounts receivable.
Compare these ratios with previous years. Does the company have more or less difficulty collecting its receivables? The fact is that a balance sheet item is only a snapshot in time. If a large debtor pays within a week of the balance sheet date, the turnaround time suddenly shows a much rosier picture.
#4 Cash flow
Financial ratios and comparative figures are wonderful, but what really matters in a business is cash flow. A company may look great on paper because it has high revenue and good solvency. But if the debtors don't pay, a cash shortage arises just like that, jeopardizing payments to the bank, suppliers or staff. The "healthy" business suddenly has to borrow money to stay alive. Many a business has gone under because their debtors defaulted.
In the context of cash flow, the main issue is what the free cash flows are. This is the money that actually, on balance, flows into the business. The difference between net profit and free cash flows is mainly determined by depreciation (these are costs, but not expenses), investments (no costs, major expenses) and the increase or decrease in working capital (no income, receipts/no costs, expenses).
Free cash flows are available to equity providers and debt providers in the form of interest, repayments and dividends. The free cash flows provide an important indication of a company's earning power and thus of its value.
Tip: Beware of window dressing
A good entrepreneur prepares for several years before selling his business. Not everyone plays that game cleanly. For example, an entrepreneur may knowingly take on assignments that are loss-making. This is difficult for the buyer to figure out, but in the meantime the seller can present a resounding order book.
Deferring investments and cutting costs increases short-term profits. You can see that as a buyer. What you don't immediately see is that the machinery is overdue for maintenance and the staff is demotivated, because even the coffee machine has been cleaned out.
