The impact of the current economic uncertainties on businesses, particularly in the retail and real estate sectors is well-documented. However, deals are still happening, particularly in the small to medium-sized enterprise (SME) space. If you are looking at completing a deal in this environment, what should you look out for in your diligence? Even more importantly, how should you treat the findings in your valuation of the business that you are looking to buy?
Many businesses we are looking at are taking longer to get paid by their customers. This means that their debtors are older, with an associated increased risk of debts going bad. A survey by Market Finance has found that SMEs had to wait an average of 23 days to receive their money in 2019, up from 12 days in 2018.
Any valuation needs to take into account a higher level of working capital to reflect this, plus considering the likely increase in bad debt expense in future. In addition, buyers should ensure that there are adequate provisions for bad debts in the completion balance sheet.
The £25 million inventory issue at Ted Baker is well known. Levels of inventory may increase in poor economic conditions. There may be a risk that some of this inventory is not saleable and should be written down. This could particularly be the case in the retail sector post-Christmas.
With higher levels of debtors and inventory, we are seeing businesses delay their payments to their suppliers. Any ‘stretched’ creditors - that is, those beyond their normal or contractual payment terms - should be treated as a form of debt and adjusted in the purchase price. These creditors will have to be settled post-transaction.
Most valuations of businesses are driven by the future expected cashflows. Predicting the future is always hard, but it is even harder during uncertain economic times. So how can you judge if the company’s projections are reasonable and should be used as the basis of your valuation?
The first place to start would be a company’s order book or pipeline of new projects. How does this compare with similar periods in the past? Does it support the projections that are being presented?
Has the company achieved its budgets in the past? A persistent failure to meet budget does not instil much confidence that the current projections will be achieved.
Once a view is taken of the most likely future of the business, this should be used as the basis of a discounted cashflow valuation. Normally this would be cross-checked against a multiples-based valuation. It is essential that the profit measure being used for the multiple is sustainable and does not include any one-off items such as releases of provisions.
To summarise, we believe that it is still perfectly possible to get deals done, even if they are taking a little longer. However in uncertain economic times you have to be extra diligent and make sure your valuation is appropriate.