Introduction:
This article is written as a general discussion on the subject of "Due Diligence". It is for informational purposes and not intended to be a definitive guideline for your exact situation. You should consult the appropriate professionals with regard to your specific transaction or situation. Further, this article is in no way advocating, suggesting or implying that anyone engages in any type fraudulent activities whatsoever. These are simply the things a buyer should be aware of when doing due diligence in buyer a Business.
Due Diligence Defined:
The phrase is composed of two words. "Due" which the dictionary defines as "Proper or Adequate" and Diligence, which is defined as "Degree of care or caution expected of a person. Especially as a party to an agreement." Caution: is the watchword in this definition.
Financial Statements - What to look for:
Add Backs: If you bought the business through a business broker you should have received the business financial statement with a separate worksheet showing adjustments to those statements. These adjustments show the owner's benefits received from the Business besides the profit and salary he receives. These can also be defined as personal expenses that need to be added back to the profit. Depreciation, incomes taxes, interest expense are add backs that are not personal. Personal includes such things as family auto expenses, owner life insurance, owner health insurance, business entertainment that was not really spent on clients, business trips not really for Business, Home office expenses, family cellular phones and much much more.
Make the seller show you the details on some or all of these expenses to verify that they are really personal and not actually Business expenses that shouldn't be added back to profit. Spend time asking detailed questions with the general ledger in front of you. Go through individual charges and what they mean, until you fully understand what is being added back and why.
Inventory:
Inventory of resale merchandise must be checked for two reasons. One is you have to pay for it. Be careful, you do not want to buy merchandise that is old, worthless and not saleable anymore. Only pay for current marketable product. The price you are suppose to te pay for the inventory is the seller's cost. The price for old slow inventory is negotiable. Always spot check the price and count the merchandise listed on the inventory list. Do people put down that there is three of an item when there are only two? Of course, especially when they think no one is going to be checking them out. Comparing prices from purchase invoices is how you check prices. You cannot check every item against the actual cost but you can do 5% of the items. Pick at random, not by any suggestion made by the seller or others. If you do not understand how marketable the inventory is that you are buying, hire an expert, from that industry. Your broker should be able to help you in finding someone. Do not be cheap, and think you do not need to spend the money on an expert adviser. I will take a lunch bet that they will pay for them selves many times over.
The second reason for checking inventory is that if a seller doesn't take inventory at least yearly and adjust his inventory value in his accounting records, accurately, the profit figure you are receiving will not be accurate. As a rule, the higher cost of goods sold, the lower the profit. Some business owners reduce the inventory value on the books, intentionally, to a lower value so as to make the Business show a higher cost of goods sold, which then creates a smaller taxable profit. If they do this year after year, the profit may or may not be accurate for the current year. It might take a CPA to figure this one out for you, if you do not have a background in retail.
Equipment value:
Next thing to check on the finan
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