FREE online courses on Mergers & Acquisitions - Chapter 3 - Reworking the Financials

 

Certainly one goal of due diligence is to remove distortions from the financial statements of the target company. This is necessary so that the acquiring company can ascertain a more realistic value for the target. There are several issues related to the Balance Sheet:

 

• Understatement of liabilities, such as pensions, allowances for bad debts, etc.
• Low quality assets - what are the relative market values of assets? Some assets may be overvalued.
• Hidden liabilities, such as contingencies for lawsuits not recognized.
• Overstated receivables - receivables may not be collectable, especially inter-company receivables.
• Overstated inventories - rising levels of inventory over time may indicate obsolescence and lack of marketability. LIFO reserves can also distort inventories.
• Valuation of short-term marketable securities - If the Target Company is holding marketable securities, are they properly valued? If the target is holding investments that are not marketable, are they overstated?
• Intangibles - Certain intangibles, such as brand names, may be seriously undervalued.

 

Generally, you should expect to see significant differences between book values and market values. If the two are not substantially different, then due diligence should dig deeper to ensure there is no manipulation of values. Likewise, the Income Statement should consist of "quality" earnings. The closer you are to "cash" earnings and not "accrual" type earnings, the higher the integrity of the Income Statement.

 

Since mergers are often aimed at cutting cost, due diligence might result in several upward adjustments to earnings for the Target Company. This is especially true where the target is a private company where excesses are common. Here are some examples:

 

• Officer's salaries are excessive in relation to what they do.
• If salaries are high, then pensions will be high.
• Bonuses, travel, and other perks are excessive.
• Vehicles and other assets are unnecessary.
• Family members are on the payroll and they play no role in running the business.
• Consultants with strong ties to management are providing unnecessary services.

 

The objective is to get back to real values and real profits that will exist after the merger. Once all necessary adjustments have been made, a forecast can be prepared.