Previously, we have explored the concept of Due Diligence its importance throughout the process of buying a business. In the following article, we will explain two important aspects to analyze during this crucial phase: working capital and other investments.
The Working Capital
We recommend that in the due diligence process that you pay special attention to the working capital (current assets and current liabilities). As such, you must compare the situation with the company’s current assets and liabilities with the two previous years and see if there are significant variations. If there are, they may be making “arrangements” to make the company appear to be worth more than what they truly are.
1- Collection days:
It is a ratio that tells us the number of days that acompany takes to charge its customers. If the collection days are getting longer, you may be exposed to a payment problem. It may represent more sales and profits in the income statement. However, in reality customers will not be paying as stated. Resultantly, there will remain the possibility that you will face a future liquidity problem.
Moreover, the company might have increased its sales a lot. However, achieving this to be able to show a temporary increase in clientele is a rather futile and useless concept to a potential acquirer. Moreover, if the days of collection have shortened a lot in recent months, the seller may be intentionally accelerating the collection. This increases cash levels in the short-term. Therefore, this increases the valuation of the company at the time of sale. If this is the case, the company you seek to acquire will be taking money that is yours away from you. You will be left with an empty space.
2- Stocks:
It is a ratio that tells us the number of days of purchases that a company has in store. If we have 60 days of stocks, everything that will sell in the next 60 days can be considered as in stock. On the condition that the stock days have lengthened in recent times, you may have a lot of obsolete material that has no outlet. If they have shortened with respect to previous years, the seller may have sold stocks in an accelerated manner so to increase cash levels in a bid to either take it for themselves, or add it to the sale price.
3- The days of payment:
It is a ratio that tells us the number of days that the company takes to pay its suppliers. If the ratio is 60 days, it means that everything that has been bought during the last 60 days has yet to be paid. If paydays have shortened, suppliers may not trust the company, along with their financial situation. In turn, they can be required to pay cash if they want to be sold their required goods. Another alternative is that they are mismanaging their payments (making them too soon). Lengthening the payments out would allow an increase in cash generation. If a company lengthens the days of payment, it may mean that it is delaying payments so that there is more cash at the time of sale. This increases its value.
Taking Action on Inconsistencies
If you see inconsistencies between these ratios and those of previous years, you should investigate further and look for an explanation. It is good that you also compare data from the competition (days of collection, payment and stocks). See if there are significant discrepancies (there should not be, but if there are, you should analyze why). Companies like INFORMA or AXEXOR can provide you with the key figures of their main competitors. It is all based on the information that they present in the Mercantile Registry.
If there are clear inconsistencies in the working capital, you should propose a lower purchase price. That eliminates the effect of the manipulations. You are looking to buy a company with a stable working capital, not one that has been manipulated last year for sale.
If the company’s sales are seasonal, do not use the end-of-year working capital fund. Instead you will have to calculate the working capital average and the debt of all the months to have a real vision of the company. Importantly, if you buy the company when the activity and cash levels of the company are low, you will have a problem financing the growth of the balance sheet. Money is needed to buy stocks and pay suppliers.
Other Investments
Another place to look for discrepancies is in investments with fixed assets (machinery). The seller may have delayed these investments so that there is more cash in the company. He can then take it for themselves before the sale. This impacts you because you will be the one who has to replace the asset that has been taken. Therefore, if you see that in the last year there was less investment in fixed assets than in previous years, look for why.
Perhaps the machinery is more obsolete than the amortization tables show. Hence, it is urgent to replace it to remain competitive. You can find yourself buying the company thinking that you do not have to invest for three years. However, the day after being announced as the new owner, you may discover an urgent need to purchase machinery. This purchase is necessary to remain competitive.
Do not stay rely on the document presented with the results of the due diligence. Review every aspect with the team responsible for analysing the company and ask them about each individual area. The toad may be hidden in one of the pages of the document. It will go unnoticed if the auditors do not explain it in detail.
Hidden Liabilities to Watch For
Look for tracks that sound strange, try to find inconsistencies even if they are small and then pull the thread. All the time that you dedicate to this will help you to better understand the company. Sometimes, it will even help avoid disappointment.
You should also investigate other issues that do not appear on the balance sheet. These include lawsuits against the company, contracts, credit to customers, agreements with employees for payment in undeclared money or commitments of future variable salary, etc.
If the facilities belong to the partners, look carefully at the lease paid by the company. Make sure the rent results shown to you are not represented well below market value. Understated rent can reduce reported costs. This may artificially increase the company’s buying price.
All these inquiries that have been mentioned can be decisive for the future of a company. It is possible that you cannot carry out a certain type of analysis without the help of an expert. If you need help carrying out this phase of buying a company, do not hesitate to contact us!