Part Two: Making Sense of Financials
Here, we’ll look at how they’re doing it.
Welcome to the second article in our series examining M&A due diligence around what we at Sikich call an era of EBITAC: Earnings Before Interest, Taxes, Amortization—and Coronavirus.
Our first article analyzed all the whats and hows for assessing a target company’s technology status, especially given the inundation of remote work and related security concerns. Now we’re turning our attention to the bottom line.
Changing with the times
Remember the old ways of working? Well, you can forget them. The pandemic has disrupted just about everything, including tried-and-true M&A financial due diligence and evaluation processes. The sooner stakeholders on both sides of a transaction realize this, the better.
Buyers now must dig deeper and examine data more closely to assess a target company’s pre-pandemic performance. Meanwhile, sellers need to make realistic valuations, which pay careful attention to timing around when the virus started affecting the business and when its impact was greatest.
Here are a few key considerations for buyers and sellers to keep in mind before embarking on the financial due diligence process.
Categorize costs and revenue
It’s challenging enough to develop accurate revenue predictions in optimal economic conditions. During a catastrophic pandemic? That’s next-level forecasting.
For buyers, accounting analyses must factor in any one-time or short-term expenditures linked to the pandemic. These might include purchases of masks and other personal protective equipment, bulk orders of hand sanitizer, laptops for remote workers and even higher-than-usual shipping costs. Ground, air and ocean transport costs all spiked during the pandemic, with China-U.S. West Coast ocean freight rates already higher than last year.
Buyers also need to ask about Payroll Protection Program (PPP) loans. Any PPP loan forgiveness qualifies as income, which analysts would need to normalize to get a more accurate indication of revenue.
Gather input on output
Along with taking a close look at the books, you need to assess and compare production rates both before and during the pandemic. This works for almost all forms of output measurement, whether it’s tons, units shipped, subscriptions purchased or hours billed.
You’ll need to understand the factors influencing any output fluctuation so you can distinguish temporary issues from potentially ongoing ones. These issues could include:
- Inability to obtain materials/supply chain disruptions
- Shipping delays affecting sales/delivery/order fulfillment
- Loss of personnel
- Lack of customer demand
For any issues that seem temporary, previous output measures most often provide the best indicators of future performance.
Play the long game
The pandemic did not affect all businesses or industries equally. Thanks to en masse lifestyle changes, some companies have seen their revenues soar in the past several months, including home fitness apps, hand sanitizer producers, entertainment streaming platforms and food delivery services.
Without proper context, their astounding revenue figures could appear too tempting to resist. Remember, these figures represent a snapshot in time, not necessarily a lasting trend. Keep the focus on forecasting to get a better sense of what the future holds. (Hint: This is where the M&A professionals come in handy, as it’s generally more difficult to accurately determine the future value of a company doing gangbusters right now.)
Create a paper trail
We can’t over emphasize the importance of documentation during financial due diligence.
Owners will need to calculate estimated revenue losses (domestic and international) that occurred because of the chaos of COVID-19. Common causes of revenue loss in 2020 include decreases in customer spending and demand, store closures, mandated shutdowns and supply chain and fulfilment disruptions, among many others.
Sellers will likely look at their numbers through a subjective lens and try to paint the rosiest possible picture. Despite their best assumptions, it’s hard to definitively prove a negative such as lost revenue opportunities. After all, you don’t receive a sales invoice for transactions not completed.
For that reason, sellers need to show their work and include the calculations used to determine the pandemic’s impact. Sellers should be as realistic as possible with the assumption that buyers will challenge the numbers. Nothing ruins a deal faster than overinflated value.
Reap the benefits of experience
The M&A world continues to spin, but it’s easy to get dizzy with so much uncertainty swirling around. Let Sikich’s team of due diligence experts give you a steady hand.
Consider us your trusted guide through uncharted territory. We’ll turn numbers into knowledge and bring the future into focus so you can make decisions with confidence.
Reach out to learn more about how we can help during your next transaction.
To learn more, read the other installments of this series on due diligence during the pandemic.