How to Analyze a Target with Limited Data?

During the search phase, independent buyers are often on their own when analyzing a potential target. Hiring a consultant may not be viable if a buyer is evaluating multiple targets, as consulting fees can quickly drive up costs.

This situation can feel overwhelming. Sellers often provide only limited data, and the Confidential Information Memorandum (CIM) is as much a sales pitch as it is substance. This article outlines quick ways to screen a business to see if it is fundamentally sound and deserving of further due diligence.

Know What You Are Looking For

Before you begin, be clear about what you want in a target company.

• Identify key parameters such as size, industry, and geographic location.

• Avoid companies in niche industries you don’t understand, or those that exceed your budget.

It’s unwise to pursue a business that doesn’t fit within your circle of competence or financial range.

Start with the Right Financials

• Request accrual-based financials: Ask for monthly accrual-basis income statements and balance sheets for the past two years, plus the year-to-date period. Having monthly financials will help you look at monthly trends, if needed.

• Ensure consistency: Sellers sometimes provide cash-basis statements for one year and accrual-basis for another. Always confirm that all statements use accrual accounting for consistency and comparability.

Financial statements prepared on different bases (cash vs. accrual) are not directly comparable year over year. Request data prepared on the same accounting basis to ensure proper comparisons.

Analyze the Income Statement

• Reconstruct annual results: Use monthly income statements to build annual income statements, and prepare a trailing 12 months (TTM) statement for the current year. If detailed monthly data is not available, rely on annual data.

• Compute EBITDA: Add back interest, taxes, depreciation, and amortization to net income.

• Check growth trends: Evaluate year-over-year revenue and EBITDA growth. Consistent growth is positive whereas declines are red flags.

• Assess margins: Calculate gross and EBITDA margins. These should be steady or improving. A low gross margin means revenue growth may not translate into meaningful profit.

• Examine fixed costs: Review SG&A (Selling, General & Administrative) expenses as a percentage of revenue. These costs are mostly fixed, so SG&A as a percentage should decrease as revenue grows. Lower fixed costs allow EBITDA to scale faster than revenue.

Assess Working Capital Needs Through the Balance Sheet

• Calculate net working capital: Exclude cash and equivalents from current assets, and exclude short-term debt (and interest payable) from current liabilities. This gives a clearer picture of operational funding needs.

• Determine the cash conversion cycle (CCC): Cash conversion cycle refer to the number of days a company will have to pay for expenses before it receives money from the sale to customers.

• Be cautious with long CCCs: A lengthy cycle signals heavy working capital needs. You may require a large line of credit or additional cash after closing just to fund daily operations, increasing your investment beyond the purchase price.

Scrutinize the CIM

The CIM highlights the seller’s best narrative, but the numbers tell the real story.

• Cross-check claims: Ensure revenue and margin trends match the actual financials.

• Spot omissions: Revenue and EBITDA in the CIM may be adjusted figures, often “window dressed.”

• Validate details: Watch for inconsistencies between the narrative as per the CIM and the financial statements provided. Any inconsistency between these two are warning signs.

Evaluate Growth Assumptions

Management’s projections are often overly optimistic.

• Compare with history: If historical growth is 5% but the CIM projects 20%, be skeptical.

• Check margin projections: Unexplained jumps in margins are red flags.

• Identify growth drivers: Ensure forecasts are backed by tangible drivers (contracts, products, expansion), not vague promises.

Further Reading

• What Is a Quality of Earnings (QoE) Report and Why Does It Matter? Explains how QoE highlights revenue/expense red flags, normalizes earnings, and assesses sustainability.

• Cash Conversion Cycle 101: A First-Time Buyer’s Guide Covers how the CCC impacts financing needs and why assessing it helps avoid overpaying or underestimating capital needs.

Bottom Line

First-time buyers don’t need a complex 50-tab spreadsheet to evaluate a company. By focusing on growth, margins, working capital, and realistic projections, you can quickly distinguish healthy businesses from those with hidden risks allowing you to focus time and energy on companies that truly deserve attention.

Ready to make smarter acquisition decisions?
At O’Connell Advisory Group, we help first-time and seasoned buyers understand the story behind the numbers. If you’re evaluating a potential acquisition and want a data-driven perspective before you commit, reach out to our team for an initial consultation.

Contact us today to learn how we can support your next deal.