Users’ Guide: Due Diligence for Acquisitions
While there are many motivations to pursue an acquisition candidate, all acquirers share a common goal: increasing their net worth. The buyer evaluates opportunities to select acquisitions where the present value of the future economic benefits received is most likely to be greater than the purchase price. The goal of the due-diligence process is both to confirm the purchase price and to determine the future economic benefits of the acquisition. The first goal of the financial due-diligence process is to validate the historical earnings of the business to be acquired. The first reason to confirm historical earnings is to validate the purchase price. While some valuations are based on the fair market value of the assets, the replacement value of the operations, or the liquidation, many valuations are based on the historical financial performance of the imaging center, either as a multiple of earnings or as the present value of the future cash flows. Therefore, it is important for due diligence to confirm historical financial performance to ensure that the purchase price of the acquisition candidate is fair and to make any necessary price adjustments. If you base your purchase price on inflated revenue or understated expenses, then your artificial assumptions raise the bar on the future earnings you need to generate to make the acquisition accretive. The second reason to confirm historical earnings is to build an accurate foundation for financial projections for the postacquisition entity. A financial projection is a compilation of assumptions, with the goal of predicting the future financial performance. Since it is impossible to predict the future, these financial projections are never 100% accurate; the goal is to increase the probability of achieving the projections. Financial projections can never be accurate if you are basing them on an erroneous starting point. Therefore, the due-diligence process needs to give you a thorough understanding of the current operations and financial characteristics of the acquisition candidate. Confirming Historical Earnings There are several questions that you should be able to answer after the due-diligence process. To confirm historical earnings, you need to confirm both the revenues and expenses shown on the financial statements. First, review the revenue to determine both the quality and sustainability of earnings. Does the booked (expected) revenue accurately represent the cash collected? Do the booked accounts receivable accurately reflect the collectible value of the accounts receivable? What is the composition of the referral base, and how diverse is the referral base? What types of studies are being performed? What is the acquisition candidate’s current payor mix? Is there risk in the composition of the payor mix? What are the fee schedules of the major payors? Is the booked revenue in line with the fee schedules? Second, review expenses to determine whether they are accurately recorded. Are there any expenses overstated, understated, or missing? Are the expenses in line with your experiences? Are the expenses tied to the source documents? Are there nonrecurring items or fluctuations in expenses? Is the center adequately staffed? How will the staffing level change after the acquisition? Will employee benefits change? What is economic impact of that change? What is the status of the facility and its equipment? What are the historical and predicted capital-expenditure rates? Will any large equipment purchases be needed to maintain the current procedural volume and support the future volume that you are predicting? Third, always rely on outside documentation, as opposed to internal financial statements prepared by the seller. Use tax returns, externally prepared financial statements, bank statements, explanations of benefits, employee handbooks, facility and equipment leases, and loan documents as your sources of information. Compilation of Assumptions The culmination of your due diligence is the creation of the most accurate financial projection for the postacquisition entity. It is imperative to have an accurate understanding of the historical performance of the center, but the financial projection is not simply a repeat of the previous year’s data for the acquisition candidate. Instead, the financial projection is a compilation of assumptions made with the goals of increasing accuracy and reducing the number of wild guesses (as well as increasing the number of educated guesses). In order to make the best educated assumptions, you need to base those assumptions on something beyond historical financial characteristics, drawing on operational, political, and macroeconomic/microeconomic factors; ask the necessary questions. How will the acquisition candidate perform under your operational model and management team? In what areas do you have advantages and disadvantages (versus the current owners)? What is your best estimate of how reimbursement will change over the next three to five years? How will the change in ownership affect referral patterns at the center? Will the current staff operate well and effectively in your culture? Do you need to make any staffing changes? The goal of your due diligence is to get an in-depth understanding of the existing operations of the acquisition candidate; by the end of due diligence, you should be able to answer any question about the acquisition candidate as well as (or better than) the current owners can answer it. The final step in the due-diligence process is using the information gained from all of your work accurately. Did due diligence change your understanding of what you were buying? Does your new understanding confirm the purchase price, require a purchase-price adjustment, or cause you to walk away from the transaction? As you refine the financial projections, you cannot make overly pessimistic and conservative assumptions, but at the same time, if the information gained in due diligence states that you should not go through with the acquisition, you cannot let all of the time, effort, and expense you have invested in the acquisition influence your decision. Therefore, after you have done all of the diligence work, ensure that you use the knowledge gained to make the best strategic decision. Perry Baker, CPA, is vice president of finance for Outpatient Imaging Affiliates LLC, Nashville, Tennessee.