Beyond that, specific areas that tend to cause problems are debtor books, stock and work in progress. Debtor books which are inaccurate (i.e. don't reflect who owes the company money) have a knock-on effect on the P&L and Balance sheet (i.e. if a debtor isn't real, the sale didn't really happen). Also, if many debtors are over 90 days, questions arise as to whether the sales related to them were real. Also, the stock must be accurate, as this may be one of the biggest items on the balance sheet. An incorrect stock figure impacts the Cost of Sale figure on the P&L which then can have a direct effect on EBITDA, which then in turn has an impact on the valuation. The same goes for the Work in Progress figure, anomalies translate directly to EBITDA and valuation in most cases. The bottom line is that if it is discovered that the books are records can not be relied on, usually it is time to consider withdrawing from the transaction. An alternative is to encourage the Seller to engage an M&A accountant to reconstruct the books and take a view on whether these new reports are a more accurate reflection of past performance and indicate what future performance will be. Some businesses are really worth the effort, sort of wiping mud off diamonds!
Declining Financial Results
This issue occurs when the Buyer engaged in the transaction and valued the business with financial results from a previous period and may even have had up-to-date management accounts when the Heads of Terms were signed. However, over the several months that the due diligence/funding phase has run, the financial results have declined. This is obviously concerning for a Buyer as they are buying future cash flow which will often be determined by the run rate of the business at closing. If the results have declined, they may assume that this is the new run rate and therefore the business should be revalued. Needless to say, not welcome news to the Seller!
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