Risk Management for M&A: Key Metrics for Financial Due Diligence

When valuing a business, public or private, large or small, investors look for value-creating potential along with the types and magnitude of risks that could reduce that value.

In fact, risk is an intrinsic part of determining value – instinctively, we are all willing to pay more for a sure thing than for a “maybe” that could be a big winner or a total loss.

In other words, we adjust the price to incorporate risk. In corporate finance-speak, the value of a business today is the sum of its future net cash flows, discounted to the present by a risk-adjusted discount rate.

The greater the perceived risks, the higher the discount rate and the lower the valuation.

This article is not a primer on corporate finance theory and is not intended to review all of the various risks a company faces.

Rather, our goal is to describe key financial risks that potential buyers and investors consider in the due diligence process, and how they affect a company’s value. 

If your business needs to raise capital or you are looking to sell in the next year or so, it is critical to understand how these risks affect the value of your business.

Be prepared to show why some risks are minor and to mitigate any major issues where possible. 

Although every company and situation is unique, and this list is not exhaustive, these risk factors and KPIs are common to most businesses.

10 Risk Factors & KPIs to Evaluate in Your Business

1. Customers

Do you know your top five to ten customers in each of the last three to five years, based on revenues?

Buyers are concerned when a handful of customers are responsible for a good portion of revenue, and any customer that consistently represents more than 10% of revenue will be seen as a risk.

The due diligence process will also examine customer retention rates (“churn”), customer losses, recurring revenue (i.e., subscription-based, automatic renewals), and repeat business.

Like the questions a board of directors would ask, buyers, want to know about customer retention and customer concentration in terms of contribution to revenue growth and profits. Is revenue growth spread out, or due mostly to a small number of customers?

If profits are due to a few relationships while most others are breakeven or worse, that is a significant risk.

2. Suppliers

Investors and buyers look for risks in your supply chain. Is a key component of your product sourced from only one vendor, with no reliable alternative source readily available?

Does your company have favorable contract terms that will expire if your business is acquired, or require re-approval upon a change of control? Is any key supplier located in a country with which the U.S. has a strained trade policy? Does a critical supplier rely on vendors that could present a risk for a key component? 

Identify any fragile links in the supply chain, and point out how those risks are being mitigated.

3. Products and Services

Identify your top-selling products or services during the prior several years, in terms of revenue. For each one, are sales growing, flat, or declining? 

Are the top sellers profitable (remember, GM went bankrupt while selling a lot of cars)? Be prepared to explain the pricing and cost structure of each product, and expect your explanations to be scrutinized. Be prepared to answer questions such as, “why not raise prices by X%?”

4. Inventory Management

Many hazards can arise from inventory accounting, and more than a few deals have been tripped up by questionable inventory practices.

Potential buyers want to know how inventory is determined, whether there is a physical count, whether any obsolete items are included and how that has changed over time. Is overhead added and relieved correctly? Is any inventory based on a unique valuation method?

Buyers will want answers to these questions and will pay special attention to the use of “percentage of completion” inventory accounting.

5. Accounts Receivable

The number of days’ sales outstanding (DSO) and accounts receivable aging schedule at a single point in time is good to know but does not tell the whole story. 

A quarterly trend analysis of accounts receivable aging and DSO over the past three years may show that receivables collections are deteriorating and may indicate a credit problem with one or more customers. As a business owner, you need to assess this risk before any potential buyer asks about it. 

6. Long-term Trend Analysis

Despite the decline in GDP caused by the COVID-19 pandemic in the first half of 2020, the US economy has not experienced a lasting downturn since the 2008-2009 Global Financial Crisis. Buyers and investors prefer to evaluate performance over long periods of time to understand how revenues have been impacted by the overall business cycle, or by fluctuations within a specific industry (e.g., the energy sector).

Business owners should be prepared to explain how commodity prices impact profits, why certain costs have been increasing as a percentage of revenue, or why spending in certain areas has decreased.

7. Capital Expenditures and Asset Turnover

While capital expenditures do not affect EBITDA, they are a critical aspect of the cash flow projections used to derive valuations.

Buyers tend to think in terms of “maintenance” and “total” CapEx.  Maintenance CapEx (not to be confused with repair and maintenance expenses) is the portion of annual capital expenditures needed to keep today’s long-term assets functioning smoothly.

The balance is for expanding long-term assets (for technology or IP-based companies, buyers conduct a similar analysis on research and development spending).

The trend in the fixed asset turnover ratio is a quick way to evaluate whether there has been too little or too much spent on fixed assets.

Buyers want to know that long-term assets are in good working order and that CapEx has not been deferred to such an extent that major expenditures will be required not long after closing. On the other hand, sellers should avoid spending too much on projects that will have uncertain future benefits. 

8. Add-backs, non-recurring charges, and normalization adjustments 

Private companies are managed differently than public companies or companies with outside investors. Closely held businesses may have unusual expenses, adjustments, or charge-offs that must be fully explained to potential buyers.

Add-backs are expenses that are clearly not related to running the business and will not continue after a sale, such as family members on the payroll who do little work, or a retired Chairman who still receives a salary.

Non-recurring charges are items such as one-time severance costs, inventory write-offs, or start-up costs for a new business unit or location. Normalization adjustments may include unrealized gains or losses, litigation expenses, or over-market rent or owner’s compensation. Sellers should prepare pro forma historical financial statements that fully account for all of these adjustments.

9. FTE Metrics
Performance measures per full-time equivalent (FTE) employees are frequently used to compare a potential acquisition against companies in a similar line of business that has a larger or smaller workforce.

Sales and profits per FTE are the most common metrics – if revenue and/or profits per FTE in your company are much lower or much higher than in a business that is similar to yours, potential buyers would want to know – and you want to know before they do.  As always, trend analysis over many years can reveal important information.

10. NOPAT and debt-free, free cash flow 

Sophisticated buyers will almost always prepare their own forecasts for an acquisition target, including Net Operating Profit After Tax and free cash flow projections.

A buyer’s model may include a scenario that reflects potential synergies that would arise from a transaction. This will be part of the business case presented to executive leadership or a board of directors. Be ready with your own forecasts, for comparison.

At the beginning of this article, we said, “the greater the perceived risks, the higher the discount rate and the lower the valuation.”

The word “perceived” was not tossed in casually.

It is critical for business owners to understand that when potential investors perceive risk, they lower their valuation, whether that perception is accurate or not.

Therefore, it makes financial sense for business owners to spend the time and effort needed to clean up the company’s books and records, to be ready to defend forecasts with hard data, and so on.

That will decrease perceived risk and increase valuations, your ultimate goal.