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Why Accurate Valuation Matters Accurate valuation is essential when buying or selling a business....
Why balance sheet review matters in due diligence
So let's unpack how do we review the balance sheet what does that look like
The balance sheet evaluation provides this comprehensive picture of the financial health and stability of the company
When you're doing any level of due diligence I always say cash is king
How cash moves through the business may also look different than what is being shown on the financial statements
If you're doing an asset purchase you're buying what is on this balance sheet
So what that looks like is really the crux of why this analysis is so important
Cash management and how money moves through the business
It starts with examining the cash management
You are going to evaluate:
- the bank accounts
- how the company moves cash through the business
You want to understand the cash practices of the company
Are they using multiple accounts
Are they using a few accounts
Accounts receivable and aging schedules explained
Accounts receivable is likely one of your most significant current assets on the balance sheet
The ways you can assess the accounts receivable is by pulling an aging schedule
Typically aging schedules will show:
- 90 days
- 60 days
- 30 days
Most invoices are due within net 30 days
Government municipalities may operate as 60 days
If you're not comfortable with the lingo around accounts receivable such as aging schedules net 90 60 or 30
Do some independent research
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Accounts payable payroll liabilities and vendor terms
The accounts payable shows what is currently outstanding
- vendor payables
- payroll liabilities
When accounts payable is significantly lower but accounts receivable is going up
That signals vendors are requiring faster payments than what is coming in the door
Cash is coming out the door faster than coming in
That can cause what is known as a cash crunch
Inventory considerations in asset heavy businesses
Inventory might be very applicable or it might not be applicable at all to your deal
In manufacturing deals inventory is a significant component
- raw materials
Inventory is going to be probably your most important evaluation of this balance sheet
Balance sheet review within financial due diligence
The balance sheet review is a component of financial due diligence
Once you obtain a letter of intent you are going to enter the financial due diligence period
Within that there are several analysis you should be doing to assess the financial health of the business
One piece of that is the balance sheet review
90 day due diligence timeline
A 90 day due diligence period
What is the first 30 days look like
In the first 30 days:
- kicking off financial due diligence
- balance sheet review
- bank process
Running monthly balance sheets in QuickBooks
Generate a monthly balance sheet report
Go into QuickBooks
Run the period of analysis
Typically a three year period
When you look at this balance sheet
What do you see
What things stick out
What questions would you ask management
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Case study accounts receivable red flags
Accounts receivable goes from:
- 685000
- 553000
- 328000
- about a million
Something has changed in the last 12 months
This is a concern for a business acquisition
You want to make sure that those balance sheet items that are sitting in accounts receivable are collectible
Questions to ask:
- have there been changes to payment terms
- have you acquired new customers which may mandate less favorable terms
If accounts receivable is increasing
I would expect revenues to significantly spike
Cash declining while accounts receivable increases
While accounts receivable increases
Cash declines
Is the business requiring more cash to operate
You need to understand:
- the cash activity
- the cash needs of the business when you're inheriting the business on day one
Accounts payable changes and cash crunch risk
Accounts payable:
- 1.4 million
- about 65000
Vendors are requiring faster payments than what is coming in the door
Cash is coming out the door faster than coming in
That can cause a cash crunch
Intercompany balances and consolidation risks
Intercompany activity between shops
On a consolidated basis should be very close to zero
You want to:
- understand the components
- make sure nothing is slipping through the cracks
Loans from shareholder and closing considerations
Loans from shareholder
Owner related
Best practice:
- paid off
- settled prior to closing
Final Thoughts
The balance sheet has a lot of great fundamentals
By isolating and analyzing it at the entity level
It gives you a clearer understanding of:
- the health of the balance sheet
- the business that supports it
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