Acquiring a business can be an exciting endeavor, whether it be expanding your company’s existing footprint or making a life-changing decision in becoming a new entrepreneur. In working with your financial team to finalize that letter of intent and enter into the due diligence phase, it is crucial to approach the process with discipline and not let potential future upsides overshadow the target’s risk profile. While various income multiples (EBITDA, SDE, etc.) may ‘check the box’ and get you to your purchase price range, hidden risks could impact the long-term success of the acquisition. Below are some financial red flags to be aware of when evaluating a business purchase.
Unreliable Financial Records and Inability to Produce Requested Information
Be inquisitive about the target’s monthly close process and systems. Being behind on monthly reconciliations and not having the most recent months closed could be an indication of problems to come. Timely internal records are one typical indicator of a well-run company, which will assist management of the company. If a target’s financial records are incomplete, inconsistent, or not well-supported, this could indicate weak financial management or inaccurate financial performance. Be wary of businesses that lack proper accounting practices or show discrepancies between tax returns and internal financial statements. Even if a target looks profitable, inefficient systems, outdated technology, or lack of standardized processes could hinder future growth. Assess operational readiness to ensure a smooth transition.
Inconsistent Metrics Within Your Historical Financial Statements
One of the first steps that we recommend in the due diligence process is reviewing historical analytics to develop your questions and identify potential areas of risk. Inconsistent ratios and significant variability in year over year revenue or expense categories could very well be a red flag. Develop these questions early in the process and formulate any testing around them in the due diligence work that ensues. A steady decline in revenue, inconsistent trends, shrinking profit margins, or increasing expenses without clear explanations can be a warning sign. Look beyond the surface-level financials to understand if these trends are temporary or indicative of deeper issues.
Unusual Cash Flow Issues
Healthy cash flow is essential for a business’s sustainability. Watch out for excessive reliance on short-term borrowing, delays in accounts receivable collection, or large, unexplained cash withdrawals. Negative cash flow patterns could signal financial distress. While availability of line of credit bank resources for strategic growth, capital expenditures, industry seasonality, or cash flow constraints is a recommended business practice, take time to review how often and how long the target is into the line of credit. Review the owner(s) distribution trends and also how often they loan monies to the company. This can be a very helpful exercise in assessing risk profile.
Excessive Debt or Unfavorable Loan Terms
High debt levels, especially when tied to restrictive loan covenants or high interest rates, can be a major burden post-acquisition. Analyze the company’s debt-to-equity ratio and its ability to service existing loans without jeopardizing future growth.
Current Ratio Trends and Working Capital
When reviewing the historical analytical trends, be sure to calculate the current ratio (current assets over current liabilities). This is a very important metric to gauge the health of a potential target. Is this ratio becoming stronger or showing declining trends? Furthermore, we recommend reviewing the company’s net working capital trends over the last 6, 12, and 18 months. This not only will provide you perspective on seasonality trends and cash flow issues, but also provide you preliminary perspective on future integration of a ‘net working capital peg,’ which is a very important protective item to include with in your stock purchase agreement or asset purchase agreement.
Concentrations in Customers or Suppliers
If a target depends too heavily on a small number of customers or suppliers, losing one could be detrimental and greatly impact the cash flow of what you may be acquiring. Assess the client and vendor diversification to ensure long-term stability. If a high-concentration client is heavily reliant on the relationship with the prior owner, be sure to inquire about future transition plans and gauge whether assimilation will be a potential hurdle.
Questionable Valuation Methods
Scrutinize how the valuation was determined and seek an independent assessment if needed. Heavier weighting to projected data or interim periods could be a problem. If the market approach is utilized, be sure to understand the comps utilized and assess if they are truly comparable. Aggressive revenue projections without reliable assumptions can distort the true value of the business.
High Employee Turnover or Low Morale
Be sure to review year-over-year payroll data. Obtain a strong pulse on the target’s turnover ratio. Frequent employee departures, leadership instability, or low workplace morale can signal underlying problems within the organization. A strong and engaged workforce is key to sustaining business success post-acquisition.
Pending or Potential Litigation
Legal battles can drain resources and create reputational risks. Investigate any outstanding lawsuits, compliance issues, or regulatory violations that could become costly liabilities.
Final Thoughts
Acquiring a new venture can be a very exciting and rewarding process. While the above red flags are certainly not all-inclusive, they are important to keep at the forefront and will help save time, money and potential future headaches. Conducting thorough due diligence, working with financial experts, and being armed with the right questions to ask will help ensure a successful transaction.
At Newburg CPA, we specialize in providing comprehensive acquisition due diligence services. We collaborate with your legal team to ensure the transactions are structure tax efficiently with the goal of minimizing any post settlement surprises. Contact us today to schedule a consultation and move forward with confidence.
David R. Natan, CPA, MST, CVA