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After weathering the 2009 downturn, investors have begun to explore long-term strategies for business expansion. However, with last year's painful experience in mind, they are more cautious in making investment decisions and some of them tend to focus more on SMEs for the benefit of smaller deal size and in hope of reducing risks.

How can investors identify the key risks of their potential investments and assess the impact of the risks if they materialize? It is common for investors to engage professional firms to conduct due diligence on the target business they intend to acquire. However, due diligence exercises are costly, which may hinder some investors with limited resources.

Nevertheless, it may not be necessary to undertake a complicated due diligence for SMEs similar to big deals that cover all areas including commercial, human resources and IT. In small deals, a precise due diligence undertaking should be adequate to highlight the key issues for the buyer to make the decision and to negotiate the price and other key terms. Some cases handled by Grant Thornton recently could be taken as examples to explain how due diligence can help investors make proper investment decisions effectively and efficiently.

Grant Thornton has recently been engaged by several European firms to perform due diligence on some Hong Kong private firms with mainland-based manufacturing plants, a very typical scenario that can be used as an illustration of typical problems faced by investors trying to acquire SMEs. The targets have accountants in both Hong Kong and the mainland. The information provided by them is very limited - only a few schedules generated from their accounting software, in a situation in which they have two sets of financial statements, one for management purposes and the other for tax reporting purposes. In these cases, the approach for due diligence needs to be adjusted, based on the limited available information, and in-depth guidance needs to be provided to the management to restructure the information for critical areas. The main purpose for doing so is to identify key issues that could affect the deal or the valuation. Some of the important areas that need great attention are highlighted below:

1. Quality of earnings

Target businesses usually provide financial statements showing earnings for price negotiation purposes. How do we know the reliability and sustainability of these figures? We should assess the quality of earnings of targets by excluding all significant one-off items, such as income from disposal of assets and special bonus payments. Ratio analyses are also performed to investigate reasons for any exceptional changes in profit ratios throughout a period, taking into account different factors such as reliance on key customers or suppliers, structure of product mix, and changes in material cost and other expenses.

2. Working capital and cash flow

Working capital analysis is an important tool for assessing the ability of a company to continue its operation and to determine whether it has sufficient cash flows to meet short-term obligations. It is important to compare the historical working capital from one period to another to see whether there are any exceptional events. For example, decreases in working capital can be an indication of a decrease in account receivables caused by a decrease in sales or delays in settlement to suppliers due to tight cash flow. On the other hand, an increase in working capital may not necessarily be a good sign as it may be caused by the tie-up of inventories.

3. Understated liabilities

Typical understated liabilities include allowances for doubtful debts and slow-moving inventories, provisions for directors and staff bonus and product warranties. These items, which can be huge and have a significant effect on the net assets of the target firm, are often overlooked by the acquirer.

Typical contractual commitments include rental commitments and purchase commitments. Guarantees may have been made for third parties to guarantee loan settlements. These commitments and guarantees could affect the cash flows of the company, post-acquisition.

4. Quality of forecasts

In China, especially for SMEs, forecast information is not prepared on a regular basis. In one of the example cases, forecasts were prepared by the owner of the company together with their accountants for due diligence purposes. They seemed to be prepared, based on the "gut-feeling" of the owner, with no supporting information, such as confirmed sales orders, research on future prices of raw materials and the comparison with historical trends of the performance of their business and the industry. As a result, they came up with forecasts with optimistic improvement in their sales and profits, despite declining results in the past. In this case, assessment of the target firm management's key assumptions and checking for evidence, which might enable the forecasts to be achieved, is needed.

5. Related-party transactions

These include transactions and balances with owners and directors of the target firm as well as with other companies under common control. The company may purchase from or sell goods to these parties at lower prices or borrow loans from them with favorable interest-rate or repayment terms. In many cases, no proper contracts were made between them. The acquirer should be aware of these arrangements and consider entering contracts with these parties to ensure they could enjoy these benefits post-acquisition, or consider the effect on the company if these arrangements are no longer available post-acquisition.

These are just some of the important points that should be considered before making investment decisions. Investors have to be very careful, despite the relatively smaller size of the deal. Proper investigation through due diligence can help them reduce the risk of investment failure.

Barry Tong is director for Corp Finance, and Gloria Leung is vice-president for Corp Finance at Grant Thornton, a member firm with Grant Thornton International Ltd, which is one of the world's leading accounting and consulting firms. The opinions expressed are entirely those of the authors.

(HK Edition 04/24/2010 page3)