When buying a business, due diligence is the process of investigating your potential investment to confirm all the facts and claims made about the business.
Conducting due diligence is the most important part of buying a business, for it is due diligence that will enable you to make the most informed decision as possible.
What Does Due Diligence Involve?
When buying a business, due diligence involves two main activities: (1) inspecting and analysing financial records and documentation, and (2) observing the day-to-day running of the business first-hand.
Beyond this, due diligence involves conducting research into the business, and finding out as much information as possible about its history and reputation, in order to help you make an informed decision.
Inspecting Financial Records
Looking at the financial records of the business in question is the first step of proper due diligence. It is important to try gain access to financial statements of the past three years.
Two of the most important financial statements to look at are the profit and loss statement, and the balance sheet. Looking at the recent profit and loss statements of the business will provide you with an idea of where the business is coming from, and where it is going.
The balance sheet will detail the business’s assets, liabilities and equity. Does the entity own substantial assets? Are there significant liabilities? These are the questions answered by the balance sheet.
Ratio Analysis
Merely looking at the historical profits, expenses, assets and liabilities is not sufficient to gain a substantial insight into the business’s financial health. Conducting a ratio analysis will provide greater insight into the financial health of the business.
For profitability, an instantly insightful ratio is the profit margin ratio. There are several variations of this ratio, but a standard version is derived by dividing net income by net sales:
Profit margin: (Net income / net sales).
For example, suppose a business’s net income is $500,000 p.a., and its net sales is $950,000 p.a. The profit margin would be (500,000 / 950,000) = 0.52, or 52%. This would mean that, for every $1 of net sales, the business earns 0.52c in net income.
The higher the margin, the greater the profitability of the business.
Trial Period
The trial period of buying a business is extremely important: it provides a first-hand insight into the day-to-day operations of the business.
Trial periods typically run for a period of two weeks. However, this may vary, and it is up to the vendor and the buyer to come to an agreement as to the length of the trial period.
The trial period is also an opportunity to see beyond the financial statements and records. It provides a concrete answer to the question of the business’s sales and expense numbers.
Reputation
Today, it is easier than ever to ascertain the reputation of a business. A quick search on the internet can present you with numerous reviews, news and information about a business.
Does the business have a good online presence? Does it have numerous favourable reviews? If yes, this is an indication of a good reputation. This can provide some level of assurance that the business has a solid foundation of customers or clientele, and may contribute to success in the future.
Conclusion
To reiterate, the foundation of due diligence is:
- Interrogation of financial statements of records
- A trial period, during which you closely observe the operations of the business
- Information search as to the reputation of the business
