“Let the buyer beware.” This old saying holds true for mergers and acquisitions. When considering whether a particular business acquisition makes sense, it is important to analyze the financial performance of the target company. This analysis will allow you to determine what value proposition you expect to receive from this transaction, and generally consists of five steps:
- Analyzing trends in the historical financial statements
- Recasting of the historical financial statements to remove non-essential, non-recurring, unusual expenses and to adjust related party transactions to estimated fair market value
- Comparing the adjusted financial statements to industry data (gross margin percentage, operating cost structure, operating profit margin)
- Constructing forward-looking financial projections of the target company operations on a stand-alone basis
- Adjusting the financial projections to incorporate anticipated changes in revenue and expenses as a result of integrating the target company operations into your existing business model
Much of the data used to perform the financial analysis is provided by the target company. Be sure to review this information with several key questions in mind:
- What is the quality of the financial data? Be sure to determine whether the financial statements have been subject to an external audit or review by a CPA. It is also critical to know if Generally Accepted Accounting Principles (GAAP) were applied consistently during the preparation of the statements. You will want to also review the target company’s corporate income tax returns to make sure they are consistent with the financial statements provided to you. Finally, if the statements rely on interim financial results, the reliability of that data must be verified.
- How were expense adjustments and projected future operating results identified and quantified? Once you’ve determined the quality of the historical and current financial data, you will want to take a closer look at future projections and recastings. Determine whether the expenses being removed are really non-essential or non-recurring, and whether or not their removal will negatively impact the ongoing business operations. Examine the projected future operating results with this question in mind: Does it make sense that this target company would be that much more profitable in the future? You will want to ensure the projections are realistic, and not overly rosy or completely out of sync with the current cost structure.
- Are the potential synergies associated with combining business operations reasonable? Once the ink is dry on any merger or acquisition agreement, the real work of combing two companies begins. That’s why it is important to consider from the outset whether any potential synergies, savings or benefits are realistic and reasonable. Determine if the revenue expectations associated with the expanded customer base make sense. You will also want to evaluate how realistic the expectations of reduced personnel or other operating expenses are. Finally, don’t neglect to consider the costs associated with the operational integration itself.
Acquiring a new business or merging operations is a significant undertaking, so performing a thorough review with a critical eye and grounded assumptions can prevent the unpleasantness of an acquisition gone bad or overpayment for a target company. Asking the above tough questions and obtaining the most up-to-date and accurate information as possible can help guide your decision-making and evaluation process. RKL has a team of consulting professionals experienced in mergers and acquisitions who can help you undertake a thorough and in-depth review. Contact one of our local offices today to get started.
Contributed by John S. Stoner, CPA, CVA, partner and leader of RKL’s Business Consulting Services Group in the Lancaster office. John provides a wide range of business consulting services, including business valuation, financial analysis, litigation support, merger/acquisition assistance and business succession planning to business clients.