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Financial Due Diligence on distressed businesses (Part 2)

I have spoken in the past about the ongoing importance of a financial due diligence process, even when buying/investing in a business for what is ostensibly a ‘bargain’ price. The contraction of the credit markets, and the inevitable trading recession which will follow, will create a number of distressed transactions in the SME sector. These transactions are vital to ensure continuity of employment for a large number of people across the UK.

The focus in such circumstances differs from typical financial due diligence investigations. In my experience the major risk areas are:

  •  If you are buying a company, you inherit its assets and its liabilities. Distressed companies inevitably have substantial liabilities, not all of which appear on the balance sheet. It is very important to be aware of the extent of these liabilities, and also to understand the agreed terms of payment.
  • In many cases a company will sell one (or more) divisions separately, rather than offloading its entire business. In these situations the business being sold will be ‘carved out’ from the existing company. As part of the process, a separate P&L is usually prepared for the division, and ensuring that the extracted P&L is accurate & maintainable is fundamental in distressed sales. This will not only prevent over-paying for the business, it will also allow more accurate projections to be prepared by the acquirer / investor.  The treatment of shared costs is always an ambiguous area, and can lead to the overstatement of profits.
  • In the current climate it is particularly important to focus on working capital requirements. The traditionally used method of looking at old balance sheets and payment terms will need to evolve to cover the affects of a post credit crunch environment.
  • Customer health. A feature of the post credit crunch economy is the precarious circumstances all customers find themselves in. It is crucial that an acquirer / investor understands how profitable different customers are. The financial health of the key customers should be undertaken, and this can be extended to the fundamental suppliers of the business.

Financial Due Diligence is still as important as it has ever been. The only difference is a change in emphasis, and with ‘distressed transactions’ the need for all advisors to move quickly is paramount to successful completion.



Date: 12th January, 2009
Author: Julian Dobbin


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