When looking to buy a company, you’ve got a long to-do list to ensure you’re investing in a business that aligns with your vision and desired outcomes. At the top of this list is performing due diligence on the target company. Since once you’ve signed the dotted line, you are now committed.
Our team has spoken at length about Quality of Earnings (QofE) Reports and why they’re so critical during this process. Because of the level of detail covered by these reports, they are a crucial step in the standard due diligence process. QofE reports can help uncover potential issues in a target company and identify nonoperational revenues or expenses to arrive to a normalized level of earnings. At the same time, they also provide important background information about the company with detailed analyses surrounding qualitative and quantitative information on the target covered in the diligence period.
However, not every buyer opts to perform a QofE, due to several factors. Sometimes the buyer is extremely comfortable and has extensive historical knowledge of the target and its industry, so they don’t find it to be a necessary step. It also might be a smaller deal, making the financial outlay to perform a full scope QofE to be cost ineffective or it might be a unique opportunity for the buyer. That being said, the timeline matters, and this step is sacrificed in the interest of speed to close. Ultimately, it comes down to the level of business risk a buyer is willing to take on a transaction.
Obviously, we’d never recommend overlooking the due diligence step. But for those on a tighter timeline or budget, we’d like to introduce you to the red flag report.
Red Flag Report: The Details
A normal QofE will take you through every aspect of a business you’re looking to acquire. From level of earnings and cashflow to working capital targets, a QofE report uncovers skeletons in a company’s closet and then some. It provides the peace of mind you aren’t going to get elsewhere. However, a red flag report is really just a lighter, less comprehensive version that many buyers prefer due to time and cost savings.
To clarify, both reports offer detailed sections on:
1. Quality of Earnings
2. Quality of Working Capital
3. Summarized balance sheets and income statements
4. Proof of Cash to Revenue
This report highlights any “red flags” (get it?) that stand out to a buyer and is much shorter in length compared to a QofE. The red flag report also offers a summary of findings that includes any financial issues in a company’s numbers that your transaction advisor uncovers.
Common Findings in a Red Flag Report
When you have your transaction advisory team conduct a red flag report, some of the more common issues they’ll identify are:
1. Incorrect application of US GAAP
2. Sustainability of revenues
3. Cost adjustments
4. Customer concentration misrepresentation
5. Sales tax, state income tax and other general tax exposures
6. Additional capital expenditure requirements
7. Related party transactions
8. Additional hiring needs
Due Diligence as a First Step
We’re not saying every business has dirty laundry to air – however, when purchasing a company, it’s better to check this due diligence box before the acquisition takes place. For a promising purchase, no matter your timeline or budget, conducting this due diligence is a step best taken first.
Learn more about our red flag report services by talking to our team – we’re kind of experts in this
