Approach to due diligence review:

Approach to a due diligence (‘DD’) and key matters to focus on during a due diligence review depends on how the transaction is being structured or the Target company is being valued. 

If the Target Company is valued at a multiple of profitability, then analysis of sustainable earnings of the Company would be the primary focus of the review. Similarly, if the assets held by the Target Company are critical to the transaction, then the focus leans towards analysis of the quality of assets. 

Following are the critical areas to be reviewed in a due diligence:

1. Quality of earnings (‘QoE’): 

• Analysis of the quality of earnings of the Company refers to process of determination whether the profitability recorded by the Company during the historical period is sustainable. 
• Historical profitability may not be reflective of the sustainable earning capacity of the Company and may be distorted due to several reasons listed below:
  • Income and expenses not accounted in accordance with the generally acceptable accounting principles (‘GAAP’): An in-depth review of the accounting practises of the Company is imperative to determine if the books of accounts have been prepared in accordance with the GAAP. The Management may not adhere to the accounting principles resulting in distorted profitability.   For example: 
• • Sales cut-off not done. Revenue being accounted immediately on dispatch of goods from the Company’s premises, whereas per the contract revenue should have been accounted on receipt of goods;
  • Finished goods inventory is valued at sales price or after reduction of profit at an adhoc percentage from the sales price;
  • Repairs and maintenance expenses or interest on loans being capitalised
  • Expenses for one period, pushed off to subsequent period 

• Impact of non-recurring or exceptional items: Sometimes, the earnings of the Company may be influenced by one-off or exceptional items like sale of non-business-related items or earning extraordinary margins from sales to certain customers or products. The impact of such items needs to be normalised to evaluate the sustainable earnings of the Company.   

• Sales bumped up at the year end, followed by subsequent reversals: The Company can resort to inflating its profitability by bumping up its credit sales and squaring-off the same by booking sales returns in the subsequent period. 

• Closing inventory quantities changed: The easiest way to inflate or deflate earnings of a manufacturing entity is to alter the closing inventory quantities. This is even more so where the auditors of the Company do not carry out a physical verification of 100% of Company’s inventories at the year end. A thorough evaluation of the quantitative movement of inventories, production and yield analysis is required to determine the accuracy of closing inventory quantities.
• Support of group companies not adequately provided for in the books: There may be instances where the Company’s operations are supported by associated or group entities in the form of management and administrative support, leasing out infrastructure, etc. However, the group entities may not be recovering the costs of such services provided on an arm’s length basis. The DD review should endeavour to determine the arm’s length cost of all such services received by the Company from the group entities and adjust the sustainable earnings of the Company by the differential amount, if any.
• Labour and other laws not being complied with: Any non-compliance with labour laws and other statutes will impact the earnings of the Company. For example:

• • Minimum wages – The Company is required to pay at least the minimum wages prescribed by the relevant authorities, but the Company may not be doing so. Companies attempt to work around this provision by reducing the number of days worked by the worker, thereby showing higher wages paid per day. Hence, as part of the DD process, attendance records need to be mapped with the pay sheets to verify the number of days worked.
  • Bonus – The Company may be paying only the minimum bonus prescribed by The Payment of Bonus Act, even though the Company may be having sufficient profits mandating it to pay maximum bonus. Lot of Companies justify paying only the minimum bonus citing the same as an industry-wide trend, which is not legal.
  • Gratuity– The Company is required to account for gratuity liability of its employees as per the liability determined by an independent actuary. The assumptions underlying the actuarial valuation needs to be evaluated carefully during DD with respect to a) number of employees considered by the actuary, b) Attrition rate, c) Increment rate. We have noticed instances where the number of employees on payroll were higher than the number of employees who were considered for determining gratuity liability
  • Provident Fund (‘PF’) – Many companies make a contribution to the PF by considering only the basic salary of the employees, whereas the Honourable Supreme Court has clearly ruled that PF needs to be contributed on all allowances, except certain allowances mentioned in the PF Act. 
    
    
• Calculating sustainable earnings of the Company may be imperative in transactions wherein the valuation of the Company is based on a multiple of the earnings of the Company. As evident from above examples, the Company may have numerous avenues to distort the sustainable earnings, thereby increasing its valuation.
  

2. Quality of Assets:

• An analysis is carried out during the DD review to evaluate the recoverability value of the assets of the Company.
• The value of the assets and liabilities may be overstated/ understated in the financial statements. Some examples below:
• Receivables – A detailed scrutiny of receivables is imperative, as the Company may not have provided for or written-off doubtful or non-recoverable debtors. The Company also may not have accounted for debit notes raised by customers towards product/service defects and continue to show the same as receivable from the customer. Analysis of invoice-wise receivables, ageing and subsequent realisation from debtors should be done to provide comfort on the recoverability of receivables stated in the financial statements.
• Inventories – Inventories may be incorrectly valued due to several reasons:

• Inventories are stated at cost, whereas the net realisable value (‘NRV’) of such inventories is less than the cost. This happens when there is deterioration in quality of inventories (due to expiry of products, rusting of finished goods, obsolescence, etc). Inventories are required to be valued at lower of cost or NRV.
• Work-in-progress (‘WIP’) inventories valued at finished goods prices, instead of valuing the WIP inventories at a cost proportionate to the stage of production.
• Administration and other non-production costs included in the value of FG and WIP inventories.

3. Debt and debt-like items:

• If the Company is valued at an enterprise level, debt is reduced from the enterprise value of the Company to arrive at the equity value. The debt amount to be adjusted from enterprise value includes not only debt amount disclosed on the financial statements, but also debt-like items which may be classified as current liabilities. Below are some examples of items which constitute debt-like items:

• Payables stretched well beyond their due credit period;
• Unfunded gratuity liability;
• Deposits received from dealers;
• Customer advances pending to be settled within the due period;
• Payables to creditors of capital goods;
• Employee payables outstanding beyond a reasonable period;
• Government dues unpaid beyond due date;
• Contingent liabilities on account of ongoing litigations and having a high probability of crystallising;
• The diligence report needs to tabulate and quantify such debt-like items for the perusal of the investor, as then the investor can readily deduct such items from the enterprise value of the Company to arrive at the equity value of the Company.

4. Normalised working capital:

• Determining the normalised working capital in the business is tricky and quite subjective. But the question is what is the need to determine normalised working capital in the business?
• Normalised working capital indicates the level of working capital required to be maintained in the Company for the smooth running of operations. A sustained squeeze on such working capital level will result in delays in payments to vendors and other creditors and thereby hamper the business and impact the goodwill of the Company.
• The term-sheet agreed between the Investor and the Company, may also specify terms regarding normalised working capital to be maintained in the business at closing. Usually, the Company gets valued at a multiple of the profitability as per the last reported financial statements or profitability as per the trailing twelve months from the agreed date. However, by the time a transaction is closed, substantial time period would have elapsed from the period which is used as a base to value the Company. 
• Hence, it is imperative to validate that normalised working capital is maintained in the business at closing, as otherwise, the promoters may have incentive to take out cash from business in the form of payouts, dividends, etc leading to working capital squeeze. 
• For example, consider the following illustration, where the Company is valued at 7x normalised EBITDA of the financial year ended 31 Mar 2019 (‘FY19’):

   

How to ascertain the normalised working capital of the Company?

• Evaluating if the reported working capital as at any date represents a normalised level requires judgment and is subjective, to say the least.
• There may be genuine reasons for decrease in receivable days and the inventory days at closing may be lower than the financial year-end due to seasonality in the business. 
• Working capital should be evaluated in terms of number of days of sales or some other relevant parameter, rather than just the amount. This is because if the sales are higher for the current period, the working capital amount may be higher than the previous reported amount but may still not represent a normalised level.
• All debt-like items should be ignored to determine the normalised level of payables. Similarly, long outstanding receivables and advances need to be excluded to calculate the normalised working capital level.