Last time around we looked closely at what due diligence is. We agreed that taking a very close look at what you are about to buy is not only a good idea it’s a prudent one too.

But who is expected to carry out the due diligence process and what does it entail?

Who Does It?

As with most things in life and especially in business, the answer to this largely depends on how much time you have and how deep your pockets are.

There are three main candidates in the small to medium business end of the market place.

Your lawyer/attorney, your accountant and yourself.

Just in case you hadn’t noticed, legal folk are expensive. To pay for one to do most of the donkey work does not make sense. That’s your job.

It would make a lot of sense however, to leave them out of the loop until the bulk of the due diligence groundwork had been covered and just run things through with them before you go to contract.

However, if you have any suspicions that things are not as they seem or should be, or things are starting to get a little bit too complicated, you owe it to yourself to take advice.

Especially if the seller’s business may have had some recent legal trouble or it is a complicated deal involving a lot of license transfers, it would make sense to get your lawyer in to do some specialist checking for you.

Your accountant is not going to come cheap either, so again here similar advice, use him for the complicated specialist checking of the financial picture of the business or if you suspect something is not 100% above board or crystal clear to you.

To check the books yourself first and then have a quick run through with him to double check your findings and thoughts, would be a sensible approach.

Basics To Look For In Financial Information

Official financial documents such as government tax returns are unlikely to give you a true picture of the financial standing of a small to medium sized business (and often a larger one too!).

Checking The Books

More often than not the expenditure records will be more accurate but if the revenue figures have been adjusted to avoid tax then probably so have the expenses too.

A better bet will be the owner’s ‘true’ books. Some owners may use an old ledger book but nowadays it is usually some kind of computerized system such as Quick Books.

These are normally the most accurate records available so make sure you are prepared to sit down with the owner and go through them with him to try and understand his accounting methods, however quirky they may be.

If you are looking at a business that is not cash in hand based then there is every chance that the official records are as accurate as you need them to be. In this case, get a full set of accounts from their accountant to include a Profit & Loss statement as well as a Balance Sheet.

In any business, especially cash in hand based, get all of the bills and payroll information available for the past 3 years if possible. At a minimum, this should tell you what the true company expenses are and from that you should be able to ‘guestimate’ income statements.

If there are absolutely no sufficient accounting records to base any analysis on then the only viable alternative is to spend a week or so literally counting the takings with the owner. The onus is on the seller to prove his statements and claims and so he has to be prepared for this if he cannot prove them any other way.

As well as verifying income and expenditure you should also be looking for any trends in the figures observed.

Has the income fluctuated greatly during the last one to three years? If so ask for an explanation why? Are there seasonal variations in the business levels? Are declared profit margins within industry norms?

In the balance sheet look at accounts receivables to check for slow paying customers. Have they been having trouble collecting payments? Bad debtors look okay on the revenue side but they do not translate into any profits, just losses on the cost of sales not paid for!

Make sure you know if you will need to take over any payments for any loans or leases? Are there any other financial commitments that you would be liable for once you have taken the business over?

Pay particular attention to anything that will affect your cash flow. What amounts of money need to be laid out each week or month to keep the business afloat?

After all this ferreting around and collecting of information, you should now be in a good position to judge what affect you can have on the future profitability of the business.

What changes can you make, which direction will you be taking the business in, what undeveloped opportunities have you discovered?

Next step is to take all this information and analysis and prepare your own projected financial statements,  projected profit & loss statement and a projected cash flow statement.

Either you or your accountant should also run up a couple of different scenarios with different levels of income, different cost assumptions. Using Excel on any other spreadsheet software, this can be a massively valuable exercise and not as daunting as it may first seem.

Being prepared is the biggest precaution any successful businessman can take. Due diligence is all about being prepared before the purchase. You need to know whether this is the right business for you to buy.

Next week we will look at other aspects of the business that you need to examine to make sure that the all important due diligence process truly protects your best interests.

Remember, knowledge is power and you are accumulating new knowledge at an amazing rate. By reading these articles and carrying out this research you are placing yourself in the top 5% of entrepreneurs.

Feel good about that? You should!

This article was written by Brian K Fitzgibbon CPA.

Brian is an experienced accountant and small business consultant. He runs his own business, lectures extensively on small business topics and has checked out and valued many hundreds of small businesses for buyers.

Brian is also the author of the highly acclaimed and invaluable
"How To Value A Business And Buy It Without Fear"
A do-it-yourself guide for first-time and experienced buyers alike.

To download a FREE Chapter from Brian's book please follow this link: "HowToValueBusiness.com"

May 18th, 2009 | Tags: buy a business, buying a business tips, due diligence | Category: articles | Subscribe to comments | Leave a comment | Trackback URL  |