As the COVID-19 pandemic continues to disrupt the economic environment, your business might need to reconsider the steps it takes during a transaction to help reduce risks and losses.
Returning to the fundamentals of due diligence, however, can offer useful insights for businesses during this time.
Below we explore four focus areas private equity firms and strategic buyers should keep front of mind when performing due diligence on other companies in the current environment.
1. Free Cash Flow Versus EBITDA
Despite the disruption, investors continue to focus on EBITDA, or earnings before interest, taxes, depreciation, and amortization. However, cash has also become a key metric in establishing valuations in certain industries in order to assess a company’s profitability and ability to weather adverse situations.
Investors should go beyond their typical adjusted EBITDA analysis and expand analyses to assess a business’ free cash flow.
For example, the amount a business spends in annual capital expenditure could become part of its normalized earnings, even if generally accepted accounting principles (GAAP) permit the capitalization of those costs.
2. Short-Term Cash Flow Forecast
Buyers don’t typically spend significant time analyzing and vetting a company’s short-term—three to six months—forecast. With so many unpredictable variables present as a result of the pandemic, however, cash forecasts should be based on sound and verifiable assumptions.
The accuracy of revenue forecasting analyses can vary by sector. For example, companies that are customer contract-based have a better visibility of future revenue and billings. As such, buyers should examine a company’s current backlog in detail and verify its accuracy by obtaining the associated customer contracts. This can help confirm the amounts disclosed, timeline of billings, and cash collections.
Accounts receivable analyses should go beyond the historical trends of analyzing aging and bad debt. Deal advisors should consider discussing each significant receivable with the seller and ask for recent communications with their customers regarding their collection status.
For certain material receivables, and upon approval from the seller, a buyer could potentially ask to verify timing of collection directly from the customer.
3. Customers and Customer Channels Analysis
Understanding a company’s customer base is critical in terms of revenue concentration, locations, sectors, sizes, and other factors. These relevant criteria can allow a buyer to create profiles for each company that categorize them as high, medium, or low risk.
Such an analysis requires strong data to be inherently available in a company’s system. Fortunately, analyses can typically be performed more efficiently in middle-market deals because targets aren’t as large and the customer base might not be as wide as those of other businesses.
4. Cost Structure Flexibility
It’s possible investors will face uncertainties for the next few years as a result of the pandemic, so it will be important to deeply understand a company’s cost structure in relation to variable versus fixed factors.
Knowing how much management can scale back operating costs during challenging times—and how quickly changes can be implemented—can provide investors more confidence when making an investment. Investors should consider allocating more time and effort into this analysis during the due diligence phase.
A detailed cost analysis by department and function—separating between fixed and variable and direct and indirect factors—can help buyers categorize various costs properly and determine the level they can be scaled back when needed.
We’re Here to Help
For more insight on how to approach due diligence and mergers and acquisitions during these complex times, contact your Moss Adams professional.
Note on COVID-19
During this unparalleled time, we’re closely monitoring the COVID-19 situation as it evolves so we can provide up-to-date guidance and support to help you combat uncertainty. For regulatory updates, strategies to help cope with subsequent risk, and possible steps to bolster your workforce and organization, please see the following resources: