Due diligence for an early stage investment

What to look for in a company’s financials




5 min read

When looking at a company’s financials how do you separate the fantasy from the reality?

Historical financial information helps one to understand the performance of a business. However, when it comes to start-ups, investment decisions are heavily based on the predictions of their future trading.

Predicting future performance is challenging, especially when a business is in the early stages of development, and actual performance can vary (for better or worse) from expectations as a result of an almost infinite number of variables affecting the business.

Financial projections are often produced with one thing in mind, to persuade you to invest. Thus, forecasts vary in degrees of reasonableness from the prudent and feasible to the overoptimistic and unachievable. Establishing where you think a company’s forecasts sit on that continuum will be influenced by your understanding of the business and the market, which can be informed by analysing the financial information, to the extent it’s available. 

Some of the key elements you should consider when reviewing a company’s financial information are:

1. Context – Businesses do not operate in vacuums and external factors such as sector, geography, regulation, size, quality of management and macroeconomic conditions are among the many factors that should be considered. Tools such as SWOT and PEST analysis are helpful in identifying and considering external factors and how they could impact the performance of the business.

You should also consider the context in which financial information is produced; have the people producing the information got the right experience, data, a track record of hitting budgets etc?  Are you confident they can to produce reliable information? What are their motivations? Has the information been independently reviewed by others or audited? 

Once you have considered this, you are ready to look into the financial information of the company.

2. Analysis of financial information – First identify the business drivers. If something happened or is forecast to happen (revenue growth, margin improvement, etc.), then you need to understand what caused it or what is driving it. Identifying the drivers is an important element in understanding how the business has performed and why, and provides a clue as to how reasonable the forecasts might be.

Each industry and business has its own drivers, so it is not possible to generalise. However, here we give you some key indicators that will help you identify the most common drivers:

Income statement key performance indicators

  • Annual sales: Identify the main drivers: new products, new customers, new locations, innovation, pricing etc. Be wary of customer concentration as it increases risk and look out for contractual or otherwise recurring revenue to mitigate this. Is forecasted growth underpinned by historical trends or are we looking at a classic hockey stick with little foundation?

  • Costs and gross margins: Compare future and historical trends. Whenever there are apparent supply constraints or increasing unit costs, consider how this could affect future profit margins. Does the company have agreements in place to secure a continuous supply and purchase price?

  • EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization): Considered a proxy for cash, EBITDA is a key component of company valuations when a multiple is applied to it. Whilst it may be less relevant in maturing businesses, understanding profits (or losses) is key. Operational leverage (the extent to which costs are related to revenue) is great if turnover is rising, but what if things take a turn for the worse? Understanding the nature of costs and how they move will be crucial to analysing future profitability and assessing whether the projected costs will be sufficient to support the expected growth.

  • Sensitivity analysis: “What if” scenarios can be used to illustrate the impact of assumptions turning out better or worse than anticipated. Better? Well, it is often forgotten that many business go bust as a result of overtrading (where growth requires greater resources - ie more people, working capital or fixed assets - than are available, resulting in cashflow being impaired).

  • Extraordinary items: take note of unusual income and expenses and evaluate the criteria used to classify these as non-recurring. The company may improperly classify expenses as extraordinary in an effort to “window dress” of improve the appearance of the business. 

In respect of all of the above, don’t forget the market context; factors such as changes in competition, regulation, supplier substitution and forex movements can all mean that the past is an unreliable guide to the future.

Cash flow and balance sheet key performance indicators

A wise man once said, “turnover is vanity, profit is sanity but cash is reality”, and we couldn’t agree more - a business could be growing its sales and generating profits while being unable to meet its financial commitments with its suppliers and investors. If the business is forecasting to run out of cash you need to understand how this will be addressed and any implications for your investment. Don’t forget to think about:

  • Cash conversion: how much the company has historically converted into cash from its sales and EBITDA? Compare historical and projected ratios, and separately assess the operating cash flow, investment cash flow (such as capex) and other cash flows (such as tax, dividends or financing).

  • Other commitments: does the company have any other commitments not included in the forecast? E.g. repayment of financing, dividend payments on preference shares, etc.

The analysis discussed above will give you an indication of the company’s current performance and how achievable the forecasts might be. We would recommend a full suite of due diligence undertaken by professionals prior to investment. But even then only one thing is certain – the forecasts will be wrong. Good luck!

 


This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO LLP to discuss these matters in the context of your particular circumstances. BDO LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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