The Role of Due Diligence in Your Next Acquisition
As we outlined in a recent article, there are several critical factors that contribute to making an acquisition a success or failure. In this instalment of the McKinley Plowman Business Growth series, we’ll be digging further into the importance of what are commonly considered the key aspect, customers and revenue.
Getting the necessary information together for a DD report can be very time consuming and often more complex than it may seem, but gaining a complete understanding of the financial health and wellbeing of a business you are looking to acquire is critical in giving the project the best chance of success. Let’s have a look at a few key areas to consider when undertaking due diligence.
Without customers, there is no business to purchase! When you’re looking at acquiring a business, it’s important to look at existing and future clients or customers. The main metric is generally the overall numbers, however just as important is the average spend and frequency of purchasing of that customer. If it’s a client-based business you’re evaluating – how many clients are on board at the moment? Howe many transactions do they undertake each year? How many leave each year compared to the amount coming in? What values are attached to those comings and goings?
Alternatively, businesses who sell products to customers in a traditionally once-off setting, what is the overall profile of the average customer? Which demographics are represented? What strategies are in place to bring in new customers, and to entice previous buyers to come back and buy again?
While these just scratch the surface of digging into a business’ client/customer profile, understanding those who benefit from the products or services on offer plays a major role in identifying the value and future prospects of the business.
Quality of Revenue
Broadly speaking, the quality of a business’ revenue can be divided into two categories: high- and low-quality. Defining one or the other comes down to risk – high-quality revenue reduces risk, while low-quality increases risk. Factors that influence this rating include: revenue continuity (e.g. long-term customer contracts); revenue diversity (the average % amount of total revenue generated by a single customer); and profitability (overall net financial gain/loss, margins, competition etc.).
Sustainability of Revenue
In short, this means how well do the levels of revenue hold up over time. If you were to purchase a business and the customers all left after 6 months then you would want an insight into that in advance in order to ascertain if that is an acceptable life cycle of a customer.
Depending on the industry there are certain benchmarks for sustainability of revenue. Generally the longer life of revenue the better that is for the business. Think of a chicken laying eggs. The longer the egg laying life of that chicken the better.
Looking at different angles, did anyone really predict (until very recently) the impact of COVID-19 on their revenue. We’d suspect less than 1% of business and mainly those who took out the appropriate insurances did. This is a classic example of something impacting revenue sustainability.
Profitability of Revenue
As revenue takes into account the income earned by the business, its crucial that the figures associated with revenue are greater than that of the outgoing expenses. For example, if the target business is pricing a job at $10,000, but has to invest $11,000 to get it done, then this won’t bode well for the success of an acquisition. Therefore, it’s crucial to look at the bigger income picture and not be too blinkered by high revenue figures.
Profitability of Revenue - Analysis
|Good Signs||FACTOR||Bad Signs|
|High||Barriers to Entry in Target's Industry||Low|
Table: An example of some factors to consider in when analysing revenue
When you buy a business, you buy the right to future revenue. In order to have a level of accuracy in your predictions you then need to pull back to view the bigger picture.
Look to see how that business has evolved over time to get where it is now, and then looking towards the future.
Historic: This takes into account things like growth or decline in revenue over recent years, the foundations of the business (how it started, previous management etc.), and any notable challenges or roadblocks in their industry. Around that last point, if the business in question has been weathering the storm of a tough industry downturn, for instance, its financial performance and ability to stay afloat is a strong indicator of how well-run and resilient it is; as well as a marker of the competency of its leadership team.
Current Position: The here and now. A snapshot of the target business’ present financial state, including total revenue, number of clients, average fees/sales and earnings before interest and tax (EBIT). Also have a look at the management structure, who’s running the business, key staff and staff turnover.
Future Position: Looking ahead at the future performance of a business isn’t always easy. That said, a thorough due diligence report wouldn’t be complete without combining historical and present revenue data, combining that with the existing systems and processes within the business, and considering significant events on the horizon (including future growth plans). Putting these together allows you to get a clearer picture of the likelihood that an acquisition will be beneficial to all parties, and perhaps even guide decision-making in the event that the business is indeed acquired.
Across all of these metrics, industry benchmarking is an invaluable tool to assist in contextualising the performance of a business and more accurately assess its potential for future growth.
While the above factor into a thorough due diligence exercise, they certainly aren’t the only things to consider. Not only are there several other complex and critical points to look for, the highly technical nature of financially analysing a business is often too complicated and time-consuming for the average business owner to get their head around.
That’s where Incisive Due Diligence can help! We take on all the leg work to fully explore the ins and outs of a business you’re looking to acquire, and give you an unbiased, honest evaluation based on facts and experience. If you’ve got your eye on a business to acquire, and are keen to boost your business’ growth in 2020, give us a call on 08 9301 2200 or visit the Incisive DD information page.
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