There are many kinds of analysis needed when a company is contemplating an acquisition. For a full acquisition, involving the assumption of all financial, environmental, and legal liabilities, as well as all assets, there are a great many subsets of analysis to perform. However, for a lesser acquisition, such as the purchase of all or specific assets, the number of analyses is substantially less.
This post presents a brief overview of acquisition analysis, the obtainability of information for such analysis, and a series of topics that cover the different types of analysis work that must be conducted. This topic is of considerable importance, given a controller’s complete lack of knowledge of the adequacy of control systems within the acquisition target. Some of the analyses listed here are not strictly financial in nature, since legal issues are also noted. These extra analyses are added for the sake of being comprehensive, though the main focus of the post is on the financial analysis of acquisition targets. Follow on…
The analysis of an acquisition is like no other type of financial analysis—not because the analysis itself is different, but because of the logistics of the situation. Typically, a potential acquisition situation arises suddenly, requires the fullest attention of the accounting staff for a short time, and then subsides, either because the acquisition is judged to be not a good one or because the deal is completed, and management takes over the activities of melding the organizations together. In either case, the controller is ensconced in the front end of the process, rendering opinions on any possible corporate purchase that the chief executive officer (CEO) sees fit to investigate.
Because of the suddenness of an acquisition evaluation, the controller must be fully prepared to switch from any current activities and into a fullbore analysis mode. To do so, this post includes the bulk of analyses that one should pursue in order to determine if the condition of an acquiree is as it purports to be. However, much more than a checklist is required.
A controller and his or her staff have other duties, and cannot let them lie in order to conduct an investigation. Accordingly, the capacity of the accounting department to complete a potentially massive analysis chore may not be possible if the department is still to operate in anything close to a normal and efficient manner. Accordingly, a controller has three choices to make:
- First, if there are very few acquisition evaluations to make and the potential acquirees are small ones, then it may be possible to accept some degree of disruption in the accounting ranks and perform all the work with the existing staff.
- A second alternative is to form an acquisition analysis group that does nothing but evaluate potential candidates on a full-time basis. This is an excellent approach if a company is embarked on the path of growth by acquisition and is willing to buy as many corporations as possible.
- The third alternative is to hire an outside auditing firm to conduct the financial analysis on behalf of the company. This is a good alternative if the in-house staff does not have the time or training to conduct the work, and if there are not enough acquisitions to justify hiring a full-time team of analysts. However, using outside auditors can be an expensive proposition, and one must be careful to ensure that the audit staff used is of a high enough level of training and experience to conduct a thorough review. Thus, the number of potential acquisitions and the ability of the internal accounting staff to complete acquisition analysis work will dictate the method a controller uses to obtain sufficient analysis assistance.
Why Analyze Acquisition Candidates At All?
Having assembled the correct analysis procedures and a competent analysis staff, the question arises:
Why analyze acquisition candidates at all?
This is not a foolish question, for the answer can then be used to determine the precise types of analysis generated, which is the focus of the rest of this post.
The primary reason for analyzing an acquisition candidate is to obtain any information that will cause management to change its opinion regarding the financial condition of the acquiree. Thus, all of the financial analyses noted in the remainder of this post are oriented toward verifying and interpreting the acquiree’s financial information.
Given the preceding reason for using financial analysis, we can then add a follow-on question:
What portion of the acquiree is management contemplating purchasing? After all, there is no need to buy an entire organization. IF NOT, then why analyze all of it?
Management may be interested only in buying a specific patent, brand, or production facility. Accordingly, a controller must first ascertain the extent of the proposed purchase and reduce the scope of the analysis if the entity to be purchased is only a subset of the entire target company. For example, if the only purchase that management is interested in is a specific production facility, so that it can add to current production capacity, the controller should tailor the analysis to focus on the age of the machinery in that facility, the adequacy of its logistical systems, and the possible obsolescence of inventory that may be acquired along with it.
Once these questions have been answered, a controller can proceed through the remaining sections of this post to determine the precise sets of analysis questions to answer, in order to ensure that the type of acquisition being contemplated is fully analyzed, without wasting time on any additional analysis work.
Obtaining Information For An Acquisition Analysis
If a company is involved in a friendly acquisition, then the target company is generally willing to open its accounting books for inspection. The exception to the rule is that, if the target company is a direct competitor to the acquiring organization, then it will resist discussions of trade secrets or processes that will allow it to continue to effectively compete against the acquiring company in case the acquisition does not occur. Also, if an acquisition is of the unfriendly variety, then the opposing company will be quite active in denying access to any information whatever.
This is an especially serious problem when a company is privately held, because very little information will be publicly available. In these situations in which information is not readily obtainable, how can a controller find a sufficient amount of information to conduct an analysis?
- The first step is to dredge up all possible sources of information. One possibility is the target company’s credit report, which may list a recent financial statement (although it is usually supplied by the target company, which may not be interested in publicly displaying its financial health and therefore may not be remotely accurate). Another source is articles in trade journals about the organization, as well as a simple review of the facility.
- By counting the number of cars in the parking lot, one can make a rough estimate, based on the industry average of sales per employee, of the amount of company sales. It may also be possible to talk to former or current employees about the company, as well as its customers or suppliers.
- Another option is to talk to local recruiters about the positions for which they have been asked to recruit, which may indicate problems that have resulted in employee turnover.
- Also, the credit report will list all assets against which lenders have filed security claims, which shows the degree to which the target company is using financial leverage to fund its operations. It may be possible to hire an investigative agency to acquire more information.
- Finally, reviewing public records about lawsuit filings will reveal whether there is any outstanding litigation against the firm. All of these options should be pursued if an acquiring company is willing to spend the time and money to accumulate the information.
However, if the target company is diligent in blocking attempts at obtaining information about it, and this results in a significant loss of information, the controller will not be able to complete a full analysis of the situation. If so, it is very useful to make a list of what information has not been obtained, and what the risk may be of not obtaining it. For example, if there is no information available about a company’s gross margin, then there is a risk of making too large an offer for a company that does not have the margins to support the price.
Once all of these risks are assembled into a list, the controller should discuss them with the CEO or chief financial officer (CFO) to determine the level of risk the company is willing to bear by not having the information, or in deciding to invest the time and money to obtain the information.
This will be an iterative process, as the number of questions posed by the controller gradually decreases, and the cost and time needed to find the answers to the remaining questions goes up. At some point, the CEO will decide that enough information is available to proceed with making an offer, or that the work required is excessive, to stop any further investigative efforts, and to proceed to the investigation of other target companies for whom information is easier to obtain.
Even if there is a sufficient amount of financial information available for a controller to conduct the requisite amount of financial analysis, there may be limited access to information about other issues that could represent significant liabilities or opportunities.
Additional outside information sources that may be of use in compiling a comprehensive set of data for a prospective acquisition include:
- Stock transfer agent. This entity can verify the target company’s outstanding capitalization.
- Title search company. These organizations, of which Dun & Bradstreet is the best known, will review all public records for the existence of liens on the assets of the target company. The list of liens should be compared to any outstanding debt schedules provided to the buyer to see if there are any discrepancies.
- Patent/trademark search company. This type of company reviews all legal filings to see if there are infringement lawsuits against the patents or trademarks of the target company, and can also obtain copies of the original patents or trademarks.
- Appraisal companies. An appraisal company can provide a list of the appraised value of a target company’s assets, though it will not reveal this information without the prior approval of the target company.
If the main reason for acquiring a target company is to hire away a specific person or group of people who are deemed to have valuable skills, a controller has one of two analysis options to pursue. The first is that, if the company has chosen to purchase the entire target company, then a full-blown analysis of all assets, liabilities, controls, and legal issues must be conducted.
However, if the company has persuaded the target company to accept payment in exchange for the transfer of some smaller portion of the company that includes the targeted employees, then the analysis work becomes much more specific.
An example of a partial purchase to obtain employees is a target company’s deciding to eliminate one of its lines of business and selling the related customer list and assets to the acquiring company. As part of the transaction, the target company lays off its employees that were associated with the line of business that is being transferred to the new company. The acquiring company obtains a list of these employees from the selling company and contacts them to offer them jobs. Because of the nature of this transaction, there is essentially nothing more than a transfer of assets, which greatly reduces the amount of analysis required of the controller.
Only the following analyses should be conducted that are specifically targeted at the employees to be hired, with an emphasis on their quality, cost, and turnover:
- Investigate employee names listed on patents.
- Interview customers and suppliers about employees.
- Compare employee pay levels to industry and internal averages.
- Determine the current turnover rate in the targeted department.
- Review long-term compensation agreements.
If a company wants to acquire a patent from another company, it does not usually go to the extreme of buying the whole company. Instead, it negotiates for the patent itself, which makes the analysis work substantially easier for the controller. There are very few measures to investigate, with an emphasis on the existing costs and revenues currently experienced by the holder of the patent.
Management may require additional analysis to include the estimated additional revenues and costs that will subsequently be incurred by its use of the patent, which may vary from the use to which it has been put by the current patent owner.
The primary analyses are:
- Determine annual patent renewal costs.
- Determine current patent-related revenue stream.
- Ascertain extent of current litigation to support patent.
When a company purchases a brand from another company, it can be as simple as the transfer of the name (witness the frequent transfer of the PanAm and Indian motorcycle names), or it can be a more comprehensive transfer of all the factories and personnel who manufacture products under that brand name. More frequently, the purchase covers the entire corporate division that operates under the brand name. However, because such a complete purchase is covered in later sections by the analysis of assets, liabilities, profitability, and cash flows, the analysis in this section will be confined to just the brand name.
The analyses needed to review a brand name are relatively simple from the financial perspective, though somewhat more involved from the legal side, because one must conduct research to ensure that there is a clear title to the trademark, as well as ascertain the extent of possible infringements on the brand name and the extent and recent history of litigation needed to support the brand.
The primary analyses are:
- Determine the amount of annual trademark fees.
- Determine clear title to the brand name.
- Ascertain the amount and trend of any current cash inflows from the brand name.
- Note the amount and trend of any legal fees needed to stop encroachment.
- Note any challenges to use of the brand name.
When a company purchases a specific manufacturing facility from another company, it is usually doing so to increase its capacity. With this end in mind, the key analyses revolve around the condition and cost of the facility, so that one can determine the amount of replacement machinery to install, as well as the actual production capacity percentage, the cost per percentage of capacity, and the facility’s overhead cost.
For many of the analyses, the information the controller assembles must be for three activity levels—minimum, normal, and maximum capacity levels. The reason for the threefold format is that management may not use the facility as much as it anticipates, in which case it must be aware of the minimum costs that will still be incurred, as well as the extra costs that must be covered if the facility runs at the highest possible rate of production.
The primary analyses are:
- Determine the facility overhead cost required for minimum, standard, and maximum capacity.
- Ascertain the amount of capital replacements needed.
- Find out the periodic maintenance cost of existing equipment.
- Determine the maximum production capacity.
- Investigate any environmental liabilities.
- Determine the cost of modifications needed to increase the capacity of the facility.
A company will sometimes acquire just the assets of another organization. This is most common when there is some risk associated with the liabilities of the target company, such as lawsuits, environmental problems, or an excessive amount of debt. Also, if a company is not experienced in taking over or liquidating a fully operational organization, then a good approach is to just pay for the assets and let the owners of the target company take care of the resolution of liabilities with the proceeds from the asset sale.
When assets are purchased, the buyer can be quite selective in buying only those few assets that are of the most value, and leave the remainder for the target company. Some of these assets may be patents, brands, or personnel, as covered in previous sections. In this section, the additional analyses needed to ensure that all other assets are properly reviewed prior to an acquisition are noted. Those analyses are:
- Conduct a fixed-asset audit.
- Appraise the value of fixed assets.
- Ascertain the existence of liens against assets.
- Determine the collectibility of accounts receivable.
- Verify the bank reconciliation for all bank accounts.
- Audit the existence and valuation of remaining assets.
- Determine the value of any tax loss carry-forward.
If a company decides to purchase a target company as a complete entity, rather than buying pieces of it (as was focused on in the previous sections), then the liabilities side of the balance sheet will be part of the purchase, and will require analysis by the controller. In this section, the analyses needed to verify the target company’s liabilities are reviewed.
The main analyses are:
- Reconcile unpaid debt to lender balances.
- Look for unrecorded debt.
- Audit accounts payable.
- Audit accrued liabilities.
There are several key methods a controller should use when reviewing the profitability of a target company. One is a significant reliance on the trends in several key variables, because these will indicate worsening profit situations.
Also, it is important to segment costs and profits by customer, so that one can see if certain customers are soaking up an inordinate proportion of the expenses. Further, it may be possible (if there is a great deal of cooperation from the target company) to determine the headcount associated with each major transaction, so that one can determine the possibility of reducing expenses by imposing transaction-related efficiencies that have worked for the acquiring company. The intent of these analyses is to quickly determine the current state and trend of a target company’s profits, as well as to pinpoint those customers and costs that are associated with the majority of profits and losses.
The main analyses are:
- Review a trend line of revenues.
- Review a trend line of bad debt expense.
- Review a trend line of sales discounts.
- Review a trend line of material costs.
- Review a trend line of direct labor costs.
- Review a trend line of gross margins.
- Review a trend line of net margins.
- Ascertain the gross profit by product.
- Ascertain the gross profit by customer.
- Review a trend line of overhead personnel per major customer.
- Review a trend line of overhead personnel per transaction.
Cash flow Analysis
The analysis of a target company’s cash flows is a critical item if the entire organization is to be purchased. The reason is that, though a profitability analysis may reveal a corporation to be in healthy condition, a further review of its cash flows may also reveal that it is investing far too heavily in working capital and fixed assets, so that profits are masking a considerable need for cash.
If a controller were to miss this key item, the buying company could find itself paying for an organization that must be supported with a massive additional infusion of cash. However, if the buyer has experience in the target company’s industry and knows how to implement cost-reducing strategies, it can milk a considerable amount of cash out of the target company, possibly enough to even pay for the acquisition.
For either reason, it is very important to determine if a target company soaks up or spins off cash, in order to adopt the correct strategy for either proceeding with or terminating any further acquisition planning.
The key cash flow analyses to focus on are:
- Review trend line of net cash flow before debt and interest payments.
- Review trend line of working capital.
- Segment working capital investment by customer.
- Review trend line of capital purchases.
When acquiring a company, there is always a risk that the target company may contain a significant case of fraud that will have a major adverse impact on the price paid by the acquiring company, and that may even result in a massive drop in the acquiring firm’s stock price once the news becomes public, which in turn may result in a series of shareholder lawsuits.
Given the severity of the results, a controller must make an attempt to review any target company for evidence of fraud. Unfortunately, fraud is extremely difficult to find, especially if it is being conducted by corporate officers.
Nonetheless, there are a few steps to complete that may hint at the possible existence of fraud, and therefore lead to a targeted and more in-depth review:
- Confirm sales to major customers.
- Review trend line of accounts receivable turnover.
- Review trend line of accounts payable turnover.
- Review trend line of inventory turnover.
The task of determining possible synergies between the acquiring and target companies is one that should involve the entire management team, because the possible areas of emphasis can cover all functional areas.
The controller’s role is usually to investigate and make recommendations about synergies that are just related to the accounting role, though the controller of a smaller organization, who has a broader range of responsibility, may also recommend synergy-related changes that involve both the human resources and management information systems areas.
One of the most common failings of any acquisition is that management pays a high price for the target company in expectation of creating significant expense reductions or revenue increases through synergies, but they never materialize. To prevent this from happening, the controller should be very careful to clarify all the assumptions that form the basis for every expected synergy, as well as quantifying the reasoning behind every cost reduction or revenue increase. For example, one can determine the number of transactions per year for each accounts payable person before and after an acquisition to see if it is reasonable for the current accounts payable staff to take on all the payables work of the other company without an increase in head count.
Alternatively, is it really possible for the current sales staff to double its sales per person by selling the products of the current company as well as those of the acquired company?
These are basic reasonableness tests that the management group must closely review to see if there is a realistic chance of achieving synergies. Without this kind of detailed review, management will be more likely to base a high purchase price on poorly grounded assumptions that cannot be achieved.
The primary objective of complexity analysis is to determine if it will be too difficult to integrate an acquiree, with a secondary objective of determining the level of risk posed by the acquiree’s general level of complexity.
- One area to consider is the sources of the acquiree’s revenue. The level of complexity and risk is increased when revenue is derived from multiple businesses, since the acquirer must devote additional levels of management resources to each of those businesses.
- Complexity and risk also increase when a significant percentage of revenue is derived from a small number of large transactions that are custom-tailored to individual customers. These transactions tend to be highly volatile in their amount and frequency, making it difficult to estimate future revenue levels and attendant cash flows.
- The tax rate can also contribute to complexity and risk. This is especially true if the acquiree has located its headquarters in a tax haven, since this indicates a strong interest in tax avoidance that has likely led to the use of a variety of complicated tax avoidance schemes.
- A further indicator of tax complexity is a substantial difference between the reported level of book and tax income.
- Finally, a volatile effective tax rate indicates that the acquiree is engaged in a variety of one-time tax dodges.
While all of these issues may be caused by completely legal transactions, it clearly indicates that the company has altered its operations in a variety of ways to take maximum advantage of the tax laws, and this will require considerable ongoing effort to maintain.
Another indicator of complexity is the presence of off-balance sheet assets and liabilities, such as variable-interest entities, research and development partnerships, and operating leases. While the intent of these transactions may have little to do with dressing up the balance sheet and may be based on solid operational reasons, they are still more likely to cause sudden changes in the reported condition of the company if underlying accounting rules are altered to require their full presentation.
The key analysis are:
- Review number of revenue sources.
- Review size and volatility of individual revenue transactions.
- Review volatility of effective tax rate.
- Investigate differences between tax and book income.
- Review off-balance sheet assets and liabilities.
Contractual and legal issues
Besides purely financial issues, there are a wide array of legal issues that a company’s legal staff must peruse. The controller may be tangentially involved in these nonfinancial analysis issues, so they are included here as a reference source.
In most cases, the analysis issues noted here are related to various kinds of contracts. When these arise, a key analysis topic for all of them is to see if they can be dissolved in the event of a corporate change of control. Many contracts contain this feature, so that onerous agreements will not cause a potentially high-priced purchase to fall apart.
The non-financial analysis issues are:
- Review bylaws.
- Review the certificate of incorporation, including name changes.
- Review employment contracts.
- Review engineering reports.
- Review environmental exposure.
- Review insurance policies.
- Review labor union agreements.
- Review leases.
- Review licenses.
- Review litigation.
- Review marketing materials.
- Review pension plans.
- Review product warranty agreements.
- Review sponsorship agreements.
- Review supplier or customer contracts.
The analysis of acquisitions is an absolutely mandatory task, and one that a controller must be well prepared to complete. The task is made easier by knowing what kind and frequency of acquisition is contemplated, which allows for the preparation of a tailored set of analysis questions, as well as the formation of a specialized group of analysis personnel.
This post focused on the analyses that must be conducted in order to be assured that an acquisition target is fairly stating its financial condition and results, and that no hidden issues could substantially alter the target’s valuation or leave the acquiring company open to an unknown amount of litigation. The information on which these analyses are based is frequently difficult to obtain, and may be required in very short order, so that the deal can either be consummated or dropped. Given the time pressures involved, a controller is usually under a great deal of stress to conduct a fair and indepth evaluation. Using the detailed analysis information and related checklists contained in this post, a controller has the framework on which to base such an analysis.